HISTORIC YEAR 2014 THESIS / PRUDENTBEAR.COM

Historic Year 2014 Thesis

by Doug Noland

January 17, 2014


EM trades poorly and more China Credit developments, while the Fed hawks build their case.

I’m proceeding with the view that 2014 is poised to be a key year in economic/financial history. Actually, I suspect future historians will look back at 2013 as a critical juncture. Last year saw the Fed and Bank of Japan combine for almost $2 TN of QE. Of significant consequence, an over-liquefied and increasingly speculative marketplace shifted its sights to stocks. “Money” flooded into U.S. and (predominantly “developed”) global equities, working at the same time to spur flows and excess in corporate debt. Speculative dynamics took firm hold, with potentially profound ramifications for global financial flows and stability. Real economies became an only bigger side show. Will central banks have the resolve to pull back?

From a flow of funds basis, the Fed fatefully decided to stick with its $85bn monthly liquidity injection, in the face of overheated markets. Across the globe, Chinese officials also fatefully granted the “terminal phase” of their historic Credit Bubble an extended lease on life. Significant cracks appeared in the China/EM Bubbles, Bubbles that have been a primary “beneficiary” throughout more than five years of unprecedented global monetary inflation.

Massive ongoing global liquidity injections coupled with historic Chinese Credit growth for the most part held the unwind of these Bubbles at bay in 2013. While it’s of course early, 2014 market trends thus far are to sell EM currencies, to sell the so called “commodity-currencies” and buy global bonds that might be viewed as safe havens in a backdrop of mounting disinflationary risks.

My “Historic Year 2014 Thesis” rests significantly on the premise that inflated and destabilized global risk markets (particularly the EM “periphery”) have become highly vulnerable to waning Federal Reserve liquidity injections and an impending Credit downturn in China. As such, considerable ongoing attention will be directed to the issues of Fed policymaking and Chinese Credit.

On the China Credit front, there were further indications of trouble brewing. December Credit data were released (see “China Credit Bubble Watch”) showing, on the one hand, a meaningful slowdown in bank lending and, on the other, continued rampant growth of “shadow banking” finance. Short-term market yields spiked this week ahead of the Chinese New Year holidays, while concerns arose of a potential default in a prominent “shadow bank” investment vehicle.

January 17 – Bloomberg: “Industrial & Commercial Bank of China Ltd. is rejecting calls to bail out a troubled 3 billion- yuan ($495 million) trust product, a bank official with knowledge of the matter said, stoking concern that the nation’s first default on such high-yield investments may be looming. ICBC, which distributed the product sold by a trust company to raise funds for Shanxi Zhenfu Energy Group, won’t assume primary responsibility after the coal miner collapsed, according to the executive. China’s largest bank may be forced to repay investors, most of whom were Beijing-based ICBC’s own private banking clients, Guangzhou Daily reported… A default on the investment product, which comes due Jan. 31, may shake investors’ faith in the implicit guarantees offered by trust companies to lure funds from wealthy people. Assets managed by China’s 67 trusts soared 60% to $1.67 trillion in the 12 months ended September… ‘Nobody wants this default to become a trigger for a financial crisis,’ Xue Huiru analyst at SWS Research Co., said ‘Breaking the implicit guarantee may help the long-term development of China’s financial system, but the short-term pain would be too much for the economy to take.’”

Here at home, it was another intriguing week of comments, discussions and speeches from key Federal Reserve officials. The Statesman, Federal Reserve Bank of Philadelphia President Charles Plosser, again made his case for fundamental changes in Fed policymaking with his “Perspectives on the Economy and Monetary Policy.” Richard Fisher, Statesman and President of the Federal Reserve Bank of Dallas, made his compelling case to wind down QE with his “Beer Goggles, Monetary Camels, the Eye of the Needle and the First Law of Holes.” The so-called “hawks” are actively building a very strong case. The academic “doves” are fated to profess “deflation!”

On some key issues, Fisher and Plosser seem to be reading from the same script. The Fed needs to get out of the business of printing "money" and distorting markets. Fisher went out of his way to signal that a market correction would not dissuade him from voting to quickly wind down QE operations. Plosser again argued persuasively that the Fed has little power over structural economic issues, including the declining labor participation rate. And he “wants more commitment the Fed will truly end bond buying,” echoing Fisher’s concern that the Fed has been too quick to reverse course at the first sign of market angst.

The monetary policy debate is commonly viewed from the perspective of the “doves” versus the “hawks.” Today, a more fruitful vantage point might be between the academics and those with a broader real world and market focus. The FOMC has been called “the most academic in history.” And especially when it comes to QE and other experimental policies, the FOMC has relied heavily on abstract academic models (note Williams’ response to the Hilsenrath question below).

This week saw the launch of the Hutchins Center on Fiscal and Monetary Policy (Brookings Institute), with interesting discussions that touched upon some of the most important financial issues of our day. I have included excerpts below.

It’s worth noting the widely divergent view (from the academics) of Dallas’ Fisher, whose illustrious career includes years at Wall Street firm Brown Brothers, Harriman, along with stints at the U.S. Department of Treasury. I’ll assume it’s a first for a Fed official to use the phrase “beer goggles.” I’ll include a brief excerpt but encourage all to read his well-crafted and thought-provoking speech in its entirety.

Fisher: “For those of you unfamiliar with the term ‘beer goggles,’ the Urban Dictionary defines it as ‘the effect that alcohol … has in rendering a person who one would ordinarily regard as unattractive as … alluring.’ …Things often look better when one is under the influence of free-flowing liquidity. This is one reason why William McChesney Martin, the longest-serving Fed chairman in our institution’s 100-year history, famously said that the Fed’s job is to take away the punchbowl just as the party gets going...

When money available to investors is close to free and is widely available, and there is a presumption that the central bank will keep it that way indefinitely, discount rates applied to assessing the value of future cash flows shift downward, making for lower hurdle rates for valuations. A bull market for stocks and other claims on tradable companies ensues; the financial world looks rather comely.

Market operators donning beer goggles and even some sober economists consider analysts like [Peter] Boockvar party poopers. But I have found myself making arguments similar to his and to those of other skeptics at recent FOMC meetings, pointing to some developments that signal we have made for an intoxicating brew as we have continued pouring liquidity down the economy’s throat.

Among them: Share buybacks financed by debt issuance that after tax treatment and inflation incur minimal, and in some cases negative, cost; this has a most pleasant effect on earnings per share apart from top-line revenue growth. Dividend payouts financed by cheap debt that bolster share prices. The ‘bull/bear spread’ for equities now being higher than in October 2007. Stock market metrics such as price-to-sales ratios and market capitalization as a percentage of gross domestic product at eye-popping levels not seen since the dot-com boom of the late 1990s. Margin debt that is pushing up against all-time records.

In the bond market, investment-grade yield spreads over ‘risk free’ government bonds becoming abnormally tight. 'Covenant lite’ lending becoming robust and the spread between CCC credit and investment-grade credit or the risk-free rate historically narrow. I will note here that I am all for helping businesses get back on their feet so that they can expand employment and America’s prosperity: This is the root desire of the FOMC. But I worry when ‘junk’ companies that should borrow at a premium reflecting their risk of failure are able to borrow (or have their shares priced) at rates that defy the odds of that risk. I may be too close to this given my background. From 1989 through 1997, I was managing partner of a fund that bought distressed debt… Today, I would have to hire Sherlock Holmes to find a single distressed company priced attractively enough to buy.”

Sherlock Holmes would be hard-pressed these days to locate attractively-prices stocks, bonds, upper-end homes, commercial real estate, farm properties, art and collectables, bitcoins, etc. The Fed’s move to zero short-term rates and a $4 TN balance sheet has fueled virtually systemic inflation of asset prices coupled with a general collapse in risk premiums.

Below I’ve also included noteworthy comments from two leading Federal Reserve academics, the retiring chairman and Federal Reserve Bank of San Francisco President John Williams. Both remain staunch supporters of QE, keen to highlight the benefits while downplaying associated risks. It is worth noting that Williams, residing in the epicenter of another tech and housing boom in San Francisco, believes “our financial system is still in a risk-averse mode.” And is it even credible to state "I don’t think that the low interest rates were an important contributor to the housing bubble"?

I’m most fascinated by Bernanke’s discussion of QE risks. While downplaying the risk of inflation, he does at least recognize the potential risk Fed policy is having on financial stability. 

Bernanke: “But at this point we don’t think that – and I think I can speak for my colleagues on this – we don’t think that financial stability concerns should at this point detract from the need for monetary policy accommodation which we are continuing to provide.” Fisher, Plosser, Esther George, Jeffrey Lacker and others might today take exception with the view that QE benefits still outweigh the risks.

Away from the Fed, I’d like to commend the ongoing efforts of Harvard’s Martin Feldstein in the monetary policy debate. From a panel discussion this week at the Hutchins Center for Fiscal and Monetary Policy:

Feldstein: “John (Williams) reminds us that the standard textbook theory implies that LSAPs (large-scale asset purchases/QE) cannot affect asset prices and interest rates. We now know that that theory is wrong. The Fed’s massive purchases of Treasury bonds and mortgage backed securities drove the yield on 10-year Treasuries to just 1.7% in May of 2013. The announced plan to end the purchase program was enough to drive that rate back to 3%... But missing in all of this (Williams and others’) analysis is a balancing of the potential output gains of LSAPs against the risks generated by sustaining abnormally low long-term interest rates. Those risks include, one, potential price bubbles in equities, land and other assets. 

Two, portfolio risks as investors reach for yield with junk bonds, emerging market debt, uncovered options and the like. Three, creditor risks as lenders make loans to less qualified borrowers, ‘covenant-lite’ loans and bonds, long-term mortgages at insufficient interest rates and so on. And four, long-term inflation risks as commercial banks acquire a large portfolio of low-yielding assets at the Federal Reserve that could be converted to commercial loans. In its conclusion, in his paper and in his remarks, John (Williams) asks whether LSAPs should be a standard tool when short rates are at the zero lower bound. I think it is at best too soon to tell. We will know more when we see the outcome of the risks that the LSAP’s created.”

Things are falling into place for a momentous policy showdown between the “hawks” and the “doves.” This debate pits the complacent academics, committed to their models and ideology, versus the more reality-based officials that have seen enough to appreciate that the Fed’s untested monetary experiment is increasingly inflating and distorting securities and asset markets.

Interestingly, IMF managing director Christine Lagarde, in a speech this week in Washington, strongly warned of the global risk of deflation: “If inflation is the genie, then deflation is the ogre that must be fought decisively.” “With inflation running below many central banks’ targets, we see rising risks of deflation, which could prove disastrous for the recovery.” She clearly decided to interject herself into the unfolding Federal Reserve policy debate.

Let’s briefly return to the “Historic Year 2014 Thesis.” Policymakers do indeed already confront a historic dilemma. Increasingly, there are downward pressures on some global prices. There is growing excess capacity to produce too many things. Moreover, unprecedented Credit Bubbles in China, Brazil, India, Turkey and EM generally are today at heightened – perhaps acute - risk. These (“periphery”) Credit systems and economies were the “global growth locomotives” at the heart of the “global reflation trade.” Meanwhile, the Trillions of “money” unleashed by global central bankers gravitate to inflating asset market Bubbles, now predominantly in the “developed” (“core”) economies. Even within EM, Chinese Credit system stress and attendant higher market yields provide a powerful magnet attracting enormous financial inflows, as destabilizing outbound flows appear likely for other key EM systems.

Notably, January is turning out to be a colossal month of debt issuance, with potentially record volumes of dollar-denominated international debt issuance. It is incredible to speak of “deflation” in the face of such liquidity abundance, generally ultra-loose (“still dancing”) financial conditions and myriad indications of excessive risk-taking. Is more “money” the solution?

And the unfolding policy dilemma seems to come into clearer focus by the week: Do central banks, in their incessant war against their perceived villain, the “deflation ogre”, continue to flood global financial markets with destabilizing liquidity? Or will they begin to take into account the true enemy of financial stability: increasingly conspicuous financial Bubbles (at the “core”)?

Curiously, Bernanke and the academics avoid discussing the key risk associated with QE – the risk that has remained at the forefront of my analysis for several years now: once aggressive monetary inflation has been commenced it becomes extremely difficult to stop. Will the Fed hawks succeed in trying to rein in the Fed’s runaway balance sheet growth? Or, as exuberant market participants assume, will central banks remain the prisoners of asset market and speculative Bubble fragilities?

Q&A from a panel discussion at the Hutchins Center on Fiscal and Monetary Policy, Brookings Institute, January 16, 2014:

David Wessel: “What about the risk that what you’re doing now is sowing the seeds of the next bout of financial instability?”

Federal Reserve Bank of San Francisco President John Williams: “In terms of these issues of greater risks?”

Wessel: “Yes, how much do you worry that what you’re doing now, because we’re clearly missing both the inflation and unemployment target that you’ve set – the mandate, risk is creating the financial instability that will give Janet Yellen a lot of headaches in her job?”

Williams: “We take this very seriously. Obviously, we’ve all learned the lessons of the past decade or so. We follow very carefully what’s happening in financial markets, both in the banking part of the financial system but most importantly…this is a capital markets-based economy. So it’s just not the banks. You have to think about the shadow banking system and the rest of the system. So we’re clearly studying this. We clearly have really increased our monitoring and our analysis around this. My argument would be the first line of defense regarding issues of growing financial risk is really around micro and macro prudential policies – both by having the right policies and implementing them… I think we’ve made incredibly important strides in terms of financial stability, in terms of the stress test, in terms of our implementation of Dodd Frank. So to my mind, we are on the job on that. We are studying that carefully. And we are balancing the costs and benefits around our QE policies. I view very strongly that the macroeconomic benefits far outweigh some of these issues right now. Risk aversion today in the markets generally – you can find specific examples, farm land prices or leveraged loan prices – but broadly defined, our financial system is still in a risk-averse mode and not a risk-loving mode. So I think these concerns today are still perhaps not as prevalent as some people think.”

Jon Hilsenrath, Wall Street Journal: “John (Williams) a question for you. The Fed employed a low for longer approach after the tech bubble burst. Several years later we had a housing bubble. I wanted to ask you, what is the risk, specifically, a low for longer policy could contribute to bubbles? Does it disturb you at all that it doesn’t seem that the (Michael) Woodford models, upon which low for longer is based, take much account for the creation of bubbles. And how should this factor into the Fed’s thinking now as it employs a low for longer policy again?”

Williams: “I agree with Marty (Feldstein) on this point. Our models that we use do not take seriously that there’s a complex financial system out there that can have endogenous changes in leverage, in risk-taking. And I would also add to that our models tend to assume highly rational agents who have a full understanding of things. So bubbles never occur. So I do think in our thinking about these issues we have to broaden our minds to more of an approach that allows for the fact that these things can happen; that asset markets can get away from fundamentals for significant periods of time. Financial markets can get disrupted. My answer to your question is I don’t think that the low interest rates were an important contributor to the housing bubble. I think fundamentally flawed aspects of our regulatory environment were the key part of that story about the housing bubble. I think Dodd Frank and Basel III and a lot of things we’re doing are addressing those concerns in a very important way. That said, I do think that we have to have open minds about understanding how low interest rates for a long period of time do affect risk-taking, leverage and asset prices, as Marty (Feldstein) said. “

Brookings Institution: January 16, 2014, Liaquat Ahamed: “We know what the benefits [from LSAPs/QE] are, because they’re lower long-term rates, lower mortgage rates. So what are the costs that you most worry about?’

Federal Reserve chairman Ben Bernanke: “Well I think that some of the costs that people talk about are not really costs, and I’ll mention a couple. One cost that gets talked about is, ‘is this going to be inflationary?’ While of course it’s always possible for the Fed to raise rates too late or too early and so on, I think we have plenty of tools now at this point – we’ve developed all the tools we need to manage interest rates – to tighten monetary policy even if the balance sheet stays where it is or gets bigger. And because we can do that, that means that we can run monetary policy in a normal way, and avoid any risk of any undue inflation or other such problems. So I don’t think that’s a concern and those who have been saying for the last five years that we’re just on the brink of hyperinflation – I think I would just point them to this morning’s CPI number and suggest that inflation is just not really a significant risk of this policy.

Another concern that people have talked about is the idea that the Fed might take capital losses, which of course is not impossible. But I would say that from a social point of view we have already not only helped the economy but we’ve actually helped the fiscal situation quite significantly with the hundreds of billions of dollars we’ve remitted to the Treasury – and that doesn’t even take into account the benefits for the public fiscal of a stronger economy, more tax revenues and the like. So that risk is again not a true social economic risk. It is, if anything perhaps, a public relations risk for the Fed. But it’s not a serious economic risk.

The main risk that my colleagues have pointed to is various aspects of financial stability – or potential for financial instability. There’s always some concern, really, for any kind of easy monetary policy, that after a period of time maybe some reaching for yield or some mis-valuation of assets. And given what happened of course just five years ago, we’re extraordinarily sensitive to that risk. Now, of course, that’s really for different kinds of monetary policy. QE in addition works on term premiums to a significant extent and we simply have less knowledge and information as to how term premiums are determined, and therefore there’s an additional concern, volatility associated with the management of QE. So there are certainly some risks there.

Our strategy, though, has been to not distort monetary policy in order to address those risks directly. Indeed, insufficient monetary policy accommodation, if it leads to a weaker economy and bad credit outcomes, etc., it’s also a financial stability risk. So our basic approach has been, at least for the first, second and third lines of defense, to rely on supervision, regulation, monitoring, macro-prudential policies – that whole set of tools that we have and are developing to try to avoid potential problems. We also look very carefully at the implications of any potential kind of financial imbalance. For example, is that asset class heavily levered – is it supported heavily by leverage, which would in turn mean that a sharp drop in that valuation would lead to other types of problems. Those are the kinds of things we look at, and we greatly increased our ability to monitor and analyze those types of situations. So our goal is to address financial instability concerns primarily, at least in the first instance, through supervision, regulation and other microeconomic types of tools. But it is something that I think of the various costs that have been ascribed to QE, I think it’s the only one that I find personally credible, frankly. And it’s the one we have spent the most time thinking about and trying to make sure that we can address it the best we can.”

Ahamed: “The bottom line, for the moment you’re not worried about too much froth in financial markets?”

Bernanke: “Well, it’s always of course bad luck to make any forecast about any particular market. But the markets currently seem to be broadly within the metrics of market valuation– valuation seems to be broadly within historical ranges. The financial system is strong. The key financial institutions are well-capitalized. So we are watching this very vigilantly. We’ve developed tremendous additional capacity for doing that. But at this point we don’t think that – and I think I can speak for my colleagues on this – we don’t think that financial stability concerns should at this point detract from the need for monetary policy accommodation which we are continuing to provide.”