DANGEROUS GAME OF CHICKEN / CREDIT BUBBLE BULLETIN

Dangerous Games of Chicken

Doug Nolan

Friday, January 30, 2015


It’s difficult to imagine more challenging analysis.  The global nature of the current Credit Bubble creates dynamics and complexities dissimilar to previous Bubble cycles.  There are extraordinary uncertainties – in hyper-speculative global markets, in experimental policymaking, in unsettled societies and unstable geopolitics.  Never have market perceptions mattered as much.  And never before has global activist monetary management so impacted market sentiment and prices – well, at least going back to the late-twenties.

I have written that I am these days more worried than in 2007, and back then I was quite apprehensive.  And while today’s global risks dwarf those of 2007, complacency and faith in central bankers have become so deeply embedded in securities and derivative prices.  Never has there been such extreme divergence between inflating securities markets and deflating future prospects.  As an analyst of Bubbles, I contend with the inevitable “chicken little” issue.

This week offered important confirmation of my global macro thesis.  Greece, a eurozone member, has a democratically elected radical party now controlling parliament and a leftist government led by a charismatic radical prime minister.  A deeply disillusioned people have spoken, and they’re fed up with Greek affairs being dictated from Brussels and Berlin.  Post-Bubble dislocation and ongoing policy-induced wealth redistribution finally reached the breaking point.  Sunday’s Greek election has left wing, right wing, anti-euro and antiestablishment parties throughout Europe further emboldened.  Greece is now moving rapidly toward a conflict with the EU, with potentially profound consequences for global markets.  A “Game of Chicken” has officially commenced.

January 30 – Bloomberg (Nikolaos ChrysolorasMarcus BensassonEleni Chrepa): “Finance Minister Yanis Varoufakis said Greece won’t seek an extension of its bailout agreement, setting the government on course to enter March without a financial backstop for the first time in five years. Greece won’t engage with officials from the troika of official creditors who have been policing the conditions of its rescue since 2010. It’s five-day-old government wants a new deal with the European Union that allows for more spending, Varoufakis said at a joint press conference with Eurogroup Chief Jeroen Dijsselbloem in Athens, Friday. ‘We don’t plan to cooperate with that committee,’ Varoufakis said. ‘The Greek state has a future, but what we won’t accept has a future is the self-perpetuating crisis of deflation and unsustainable debt.’ The standoff could see Greek banks effectively excluded from European Central Bank liquidity operations and the government with no source of funding, having rejected EU aid while still shut out of international markets.”
It’s worth noting that Putin and the Russian government have courted Syriza as well as anti-euro parties throughout Europe.  As strange as it sounds here in the U.S., Putin is idolized by many of Europe’s so-called “fringe” politicians – leading political movements that are rapidly gaining power and influence across the continent.

Thursday’s headline from the FT (Sam Jones, Kerin Hope and Courtney Weaver):  “Alarm Bells Ring Over Syriza’s Russian Links: Soon after Syriza, the Greek radical leftwing party swept to power this week, alarm bells began ringing in the capitals of Europe. But it was not finance officials who were rattled but Europe’s defence and security chiefs. The day after his election as Greece’s new prime minister, Alexis Tsipras threw a grenade in the direction of Brussels: he objected to calls for fresh sanctions against Russia as a result of rising violence in Ukraine. On Wednesday, Athens went further: ‘We are against the embargo that has been imposed against Russia,’ said Panagiotis Lafazanis, the energy minister and leader of Syriza’s far left faction… ‘We have no differences with Russia and the Russian people.’ The Greek rebuff has elicited an angry — and, behind closed doors, indignant — response. EU powers led by the UK, Germany and France, have lately trodden a careful path in trying to keep the EU’s 28 member states unified on the need to impose a financial and economic cost on Russia for its destabilising actions inside Ukrainian territory. While some diplomats and analysts see Mr Tsipras’ intervention against more sanctions as an opening gambit in forthcoming negotiations over Greece’s international bailout and debt burden, others point to it as another example of spreading Russian influence in southeastern Europe.”
I am again reminded of Adam Fergusson’s classic, “When Money Dies: The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany.”  In reading a brilliant account of the German monetary breakdown, it was incredible how German central bankers remained oblivious to the reality that their printing operations were at the root of an unfolding catastrophe. Like today’s central banks, German bankers at the time believed their actions were a necessary response to outside forces.

These days it goes unappreciated that crises - ongoing and unfolding alike - emanate from an unprecedented period of unsound global money and Credit.  To be sure, financial, economic, social and political turmoil in Greece has been a direct consequence of years of unsound finance.  The euro monetary experiment, hatched during a period of optimism, integration and cohesion, is now a slow motion train wreck in today’s backdrop of growing discontent, disenchantment, hostility and disintegration. Greece, of course, must shoulder much of the responsibility.  Yet the euro currency coupled with unfettered global finance provided the noose for the Greeks to hang themselves.  Runaway global monetary inflation has ensured an abundance of nooses.

“Greek” and “Ukraine” crises this week seemed to merge into a potential geopolitical quagmire, with Russia supplying the muck.  It’s been my view that Russia’s invasion of Ukraine likely marked a historic inflection point.  The optimistic consensus view has been that Putin misjudged Western reaction to his Ukraine gambit – and that punishing sanctions would spur his retreat.  The disconcerting view, one I subscribe to, holds that the U.S. and the “West” on various fronts crossed Putin’s red line, provoking a fundamental change in the geopolitical landscape.  Not only would Western sanctions fail to alter Putin’s course, they would ensure a tit-for-tat escalation with the potential to spiral out of control.  The Ukraine conflict has again escalated.  Putin will not miss an opportunity to fracture Europe and split the “West” more generally.

For the week, Greek five-year yields surged an astounding 598 bps (to 15.00%), the high since the 2012 crisis.  Greek bank stocks collapsed.  As the markets prepare again for default, Greek CDS jump 560 bps this week to 1,732. The Russian ruble was slammed for 8.3% this week.  Russian 10-year dollar yields jumped 60 bps to 7.42%, the high since mid-December.

Greece now provides a clear and present danger to already weakened global markets.  From a more general market analysis framework, I’m watching for burst Bubble EM contagion.  To begin the year, EM has generally benefited from the perception of ongoing (“do whatever it takes”) liquidity abundance.  Yet the short-squeeze rally faltered this week.  I'm monitoring Brazil and Turkey closely.

On the back of the Brazilian real’s 2.9% Friday decline, the real fell 3.8% for the week.  Brazilian (real) yields jumped 24 bps this week (to 11.96%) with dollar yields up 28 bps to a four-week high 4.30%.  Petrobras bonds dropped a record 5% in Friday trade after a Moody’s downgrade.  Brazil these days faces an ugly mix of inflation, corruption investigations, government deficits and financial fragility.  They’ve had way too much government-directed lending and similar amounts of dollar-denominated borrowing.  Their central bank has written a huge amount of currency swaps.

The Turkish lira was slammed 3.8% this week to a new record low against the dollar.  Turkey certainly has its own corruption issues.  The Turkish central bank is now under intense pressure from the Erdogan government to aggressively slash interest rates.  Loose financial conditions have to this point sustained rapid Credit growth in Turkey, with attendant trade deficits and imbalances.  Similar to many EM economies, Turkey has issued significant amounts of dollar-denominated debt (government, corporate and financial).

On the EM currency front, this week saw the Mexican peso hit for 2.1%, the South African rand 2.1%, the Colombian peso 2.1%, the Indonesian rupiah 1.7%, the Peruvian sol 1.3%, the Chilean peso 1.4%, the South Korean won 0.9% and the Malaysian ringgit 0.8%.  It’s worth mentioning that the (offshore) Chinese renminbi lost 50 bps, trading to its lowest level versus the dollar since 2012.

Key EM equities markets were also under pressure.  Stocks in Brazil and Mexico were both down about 4%.  China’s Shanghai Composite fell 4.2%.  Turkish stocks were hit for 2.0%.

Let’s get back to Europe.  From my perspective, European crisis risk has elevated to the highest level since the summer of 2012.  Yet we’re at the phase of the cycle where disregarding risk comes naturally.  Complacency has been repeatedly well rewarded, especially back in 2012.  The bullish assumption is that the EU will flinch – that the Germans will back down as they’ve repeatedly done.  Surely Tsipras and Syriza don’t have a death wish - thus will eventually fall in line to remain in the euro.

Yet this is not 2012 – and Alexis Tsipras is a different character.  I don’t see Merkel and Schaeuble offering concessions to the firebrand Greek PM.  The German public stance against further accommodations for Greece has hardened significantly.  Germany now has its own anti-euro movement enjoying solid momentum.  German and EU leadership will be tougher negotiators now than in 2012, wary to not further invigorate rising anti-euro parties and sentiments throughout the eurozone.  At the same time, Tsipras is a man with a mandate and clearly on a mission.  He’ll relish a Game of Chicken with major global ramifications.  “Grexit” – and all the havoc that would entail - would be blamed on the EU and Germans.

And there’s that other Game of Chicken.  Putin is a real wild card here.  Do hostilities continue to ratchet up in Ukraine?  Does Putin see the Greece situation as an opportunity to stick the EU in the eye?  Does he relish the opportunity to destabilize “Western” financial markets – payback time for the sanctions and collapse in crude prices?  Could the Russians see the current backdrop as an opportune time to ratchet up the new “Cold War”?

There is a potentially quite important downside to “do whatever it takes” “money” printing and market manipulation.  At this point, Draghi has ensured that European markets would be especially vulnerable to a destabilizing shift in market perceptions and/or crisis of confidence.  European equities have begun the year with strong gains, while historic bond market mispricing runs unabated.  To this point, mounting risks – financial, economic, geopolitical and the like – have been viewed as guaranteeing only greater injections of central bank liquidity.    

The euro closed Friday trading at about 1.13 to the dollar.  The euro traded below 1.22 only briefly during the tumultuous summer of 2012.  Draghi has successfully collapsed sovereign yields.  He has also taken a battering ram to confidence in the euro currency.  The expectation is that a weak euro will help grease the inflationary wheels.  But if the markets begin to fear a Greece euro exit, the wheels could come off the weakened euro currency.  King dollar wasn’t an issue in 2012.  And if the reality begins to sink in that the ECB and others are sitting on near-worthless Greek debt, the public outrage over further ECB bond purchases in Germany and elsewhere could be further inflamed.  At this point, “money” must be flying out of the Greek banking system.  The ECB’s job just became even more difficult.  It’s that age-old illiquidity vs. insolvency issue – throwing good “money” after bad.

At this point, U.S. equity bulls aren’t losing any sleep over Greece.  Not with U.S. economic growth the envy of the world.  The consensus bullish view holds that the system is sound – now six years into a healing recovery.  To the bulls, the strong dollar and buoyant securities markets confirms their optimistic view.

I’ll provide a counter argument.  The global Credit “system” is quite vulnerable – and king dollar is increasingly destabilizing.  “Hot money” is on the move - out of EM, Europe and, increasingly, China.  Global currencies are unstable - making "carry trade" leverage problematic.  The ongoing collapse in commodities and EM currencies is creating enormous amounts of impaired global Credit.  China remains a Credit accident in the making.  The global leveraged speculating community is susceptible to de-risking/de-leveraging.

This week at home, market participants were awakened to the reality that American multinationals have major earnings exposure to both dollar strength and global economic weakness.   And the significant tightening in Credit Availability in the energy sector this week manifested into meaningful reductions in capital expenditure budgets (and job cuts).  The U.S. economy is not immune to global forces.  Yet the greatest exposure is within the financial markets.  There were certainly indications this week that contagion at the “periphery” gained important momentum.  There were as well signs that the deflating Bubble at the “periphery” is increasingly impinging the “core.”  For inflated and over-confident markets, it’s an inopportune time for Games of Chicken with really high stakes.