A PROGRESSIVELY MALADJUSTED "ECONOMIC SPHERE" / CREDIT BUBBLE BULLETIN

A Progressively Maladjusted “Economic Sphere”

Doug Nolan

Friday, March 27, 2015


March 27 – Bloomberg (by Christopher CondonIan Katz): “Federal Reserve officials, fresh from the latest round of tests designed to ensure the safety of the biggest banks, are now peering into the darker corners of the financial system as they assess the risks of another crisis.

One source of concern: tighter regulation of banks is prompting more borrowers to seek funding through the $25 trillion shadow banking system -- money-market mutual funds, hedge funds, brokerages and other entities that face fewer restrictions. ‘These institutions are a significant and growing source of credit in the economy,’ Dennis Lockhart, president of the Atlanta Fed, said…

‘They are part of an interconnected financial system that, in extreme circumstances, is prone to contagion.’ …Worldwide, shadow banking assets have grown, while banking assets stagnated, according to a report by the Financial Stability Board, a global group of regulators. Non-bank financial intermediation grew almost 7% to $75 trillion in 2013, the latest year for which figures are available, while banking assets declined less than 1% to $139 trillion. In the U.S., shadow banking -- also known as market finance -- grew almost 9% to $25.2 trillion in 2013, while banking assets increased almost 5% to $20.2 trillion. ‘One of the oft-cited examples regarding the prowess of the U.S. financial system is our reliance on market finance,’ said Lawrence Goodman, president of the… Center for Financial Stability… ‘It helps grease the wheels of the financial system.’ The grease can also magnify risks.”
So-called “shadow banking” will undoubtedly play a paramount role in the next global financial crisis. It was at the heart of the 2008 fiasco. Yet somehow “shadow banking” has been allowed to inflate unchecked over recent years – at home and abroad (especially in China). How could this be?

There was no credible effort to analyze and grasp the root causes of the 2008 financial and economic crisis. The Bernanke Fed and the Treasury moved immediately to flood the system with liquidity, backstop troubled borrowers and reflate system Credit. It’s been rationalization and justification – not to mention monetization - ever since. Inflating risk asset prices was the cornerstone of Bernanke’s reflationary strategy. Rates were collapsed to zero, providing a competitive advantage to marketable securities (at the expense of savings). The Fed quickly purchased $1.0 TN of Treasury and MBS securities. The Fed and Treasury backstopped and bailed out key players in the “shadows.” Too Big To Fail.

The Federal Reserve has been determined to paint the 2008 crisis as a consequence of poor lending standards. Excessively loose monetary policy has been absolved of responsibility. And distorted financial market incentives apparently were not culprits either.

The Fed has expounded the view of a somewhat exceptional yet classic consequence of lax supervision and egregious mortgage lending. This was most convenient analysis – a framework that allowed the Fed to toughen oversight of the banks. Market-based finance, on the other hand, was given a pass. Central to Fed strategy, after all, was the aggressive reflation of market-based Credit and the securities markets more generally. It was the Fed’s flawed doctrine and policy course that had me first warning back in April 2009 of the likely emergence of the “global government finance Bubble.”

It’s a fascinating dynamic. Importantly, “market-based” finance has evolved to be quite a misnomer. In one of history’s great ironies, securities market prices – and resulting flows of finance – have come under the direction of central government control. The capacity to intervene, manipulate and dictate securities market prices has provided governments historic sway over market forces. And, of course, few participants have qualms with governments inflating securities markets higher. In an update of Minsky’s stages of capitalistic development, I’ve referred to the post-crisis reflationary period as “Government Finance Quasi-Capitalism.”

Traditionally, central banks would adjust bank reserve requirements and short-term funding costs in an effort to regulate bank lending and inflation. Government deficit spending would seek to boost economic activity, incomes and corporate profits. The resulting mix of real growth and inflation would bring about significant effects on securities prices. Moderate annual inflation in the general price level was viewed as greasing the wheels of commerce, bolstering debtors and holders of risk assets alike. Moreover, accelerating consumer price inflation could be countered with measures to tighten banking lending/Credit.

These days, a momentous change in economic doctrine has policymakers openly targeting rising securities prices. It is believed that central bank Credit-induced wealth effects will stimulate spending, system-wide Credit expansion and, eventually, a steady 2% increase in the general price level. What began with the free-market advocate Alan Greenspan in the nineties (stealthily) nurturing U.S. non-bank Credit expansion, has regressed to open global government manipulation of sovereign bond, corporate debt, equities and currency markets.

There are serious flaws in today’s New Age doctrine that ensure spectacular failure. Generally speaking, global policy is pro-Bubble – pro-Credit Bubble, pro-securities market Bubbles, pro-wealth redistribution and pro-global Bubble-induced financial and economic maladjustment. It is pro unsustainable divergence between inflating securities prices and deflating economic prospects.

Fundamentally, market-based Credit is unstable, with this era’s great experiment requiring progressive government intervention and manipulation. Providing robust incentives for leveraged speculation ensures mispriced Credit, loose Credit Availability and boom and bust dynamics. It also ensures an inflating pool of trend-following and performance-chasing finance. 

Incentivizing flows to the risk markets as opposed to savings only exacerbates the proclivity of markets toward destabilizing speculative excess. As we’ve witnessed over the years, mounting market distortions and associated fragilities have been met with only more aggressive policy measures. A breakdown in market pricing mechanisms is celebrated as a historic “bull market.”

Importantly, it has reached the point where the risks associated with a bursting global Bubble overshadow policy discussions and objectives. Policymakers now endeavor to completely repress market self-adjusting and correcting mechanisms (i.e. “quasi-Capitalism”). Bear markets and recessions have become completely unacceptable, as this historic Bubble’s “Terminal Phase” runs its regrettable course.

There’s another profound flaw in today’s monetary experiment: The historic inflation in market-based finance and securities markets has not – will not - translate into a stable rise in the general price level. Indeed, there are sound arguments as to why policies that target inflating risk markets ensure a problematic divergence between securities prices and a general price level. Generally speaking, the global nature of Bubble distortions ensures spending and investment patterns inconsistent with some general increase in consumer prices. Wealth redistribution distorts spending patterns, with much of the U.S. and global population not enjoying spending-inducing increases in incomes and wealth. In short, I contend that targeting and manipulating “financial sphere” prices ensures inevitable “economic sphere” instability and dislocation.

A myth has prevailed that under the current policy regime central bankers control a general price level. Market prices have inflated tremendously, outstanding debt has inflated tremendously, market faith in central bankers has inflated incredibly – and all have converged to foster a historic divergence between inflated market-based finance and general consumer prices that rebuff financial sphere inflation.

Truth be told, global central bankers have lost control of pricing mechanisms – both in the risk markets and with general consumer price levels. But instead of accepting the realities of a failing policy experiment, central bankers have succumbed to only more extreme monetary inflation. Global securities market Bubbles have inflated to historic extremes, while the policy course has shifted to countries manipulating currencies in hope of countering stagnation and deflationary forces (“currency wars”). At this point, a runaway “Financial Sphere” inflation comes at the expense of A Progressively Maladjusted “Economic Sphere.”

The combination of a faltering global Bubble, increasingly powerful deflationary forces and aggressive currency market manipulation has spurred a powerful king dollar dynamic. Last week I argued that an increasingly destabilizing king dollar provoked a pronouncement of True Ultra-Dovishness from the Yellen Fed. The focal point of my market analysis will center on the currency markets, EM and the ongoing impact of Fed dovishness. The market week was inconclusive.

The Yemen meltdown and an abrupt double-digit percentage jump in crude add complexity to the analysis. King dollar enjoyed an extra boost from some safe haven buying. I would add, however, that the now prolonged global Bubble – rife with wealth redistribution and inequities – ensures an increasingly unstable and problematic geopolitical backdrop. Geopolitical risk bolstering the dollar’s safe haven appeal these days becomes fundamental to the self-reinforcing and destabilizing king dollar dynamic. This dynamic cut short the Fed-induced EM currency and market rally attempt. As the rally faded, EM weak-links this week again displayed vulnerability.

After gaining 3.1% Monday, losses in Tuesday’s and Friday’s sessions saw the Brazilian real end the week down 0.6%. The Turkish lira also had early-week gains evaporate. Rallies abruptly gave way to notable late-week selling in Latin American and Eastern European currencies.

Thursday and Friday losses pushed Brazilian equities to a 3.6% loss for the week. The heavily indebted Brazilian corporate and banking sectors came under pronounced selling pressure again this week. It’s worth noting that BNDES (Brazil’s development bank) CDS jumped 30 bps on Friday to 350 bps, rather quickly giving back much of the Fed-Dove rally. Vale CDS blew right through last week’s (pre-Fed) highs to end Friday at a multi-year high 370 bps. Petrobras CDS increased 5 bps this week to an elevated 625 bps, though prices remain below last week’s high of almost 700 bps.

After an unimpressive Fed-Dove rally, Brazilian 10-year (real) bond yields were up 14 bps this week to 13.21%. Ominously, Brazil sovereign CDS remain at elevated levels, ending the week only 18 bps below recent (pre-Fed) 11-year highs. Mexican peso yields jumped 17 bps this week to 5.86% and Colombia yields jumped 20 bps to 6.96%. After rallying on Fed-Dove, Venezuela CDS surged 530 bps this week to 4,697. Ukraine CDS jumped 325 bps to 2,674. Fleeting stabilization at the troubled Periphery…

Turkey’s 10-year (lira) yields jumped 45 bps to 8.34%, surging past last week’s pre-Fed highs. Turkey CDS increased seven to 217 bps. India’s equity Bubble showed vulnerability, with the Sensex index dropping 2.8% this week. Stocks were hit 5% in Egypt, 3% in Saudi Arabia and Kuwait, and 2% in Oman and United Arab Emirates.

Markets were unsettled here at home as well. Some of the more conspicuous Bubbles demonstrated vulnerability. The biotechs (BTK) were hammered for 4.9%, reducing Q1 gains to 17.3%. The semiconductors (SOX) were hit for 5.0%, pushing year-to-date returns down to only 1.1%. The Morgan Stanley High Tech index dropped 3.4%, as the Nasdaq Composite fell 2.7%. The Transports were clobbered for 4.9% and the REITS (BBG) fell 3.2%.

And let us not forget Greece. After trading above 18% last Thursday, Greek five-year bond yields dropped to almost 15% Thursday before ending the week at 15.6%. Greek CDS surged 300 bps Friday to 1,900. Greek uncertainty remains a major market risk.

March 27 – Financial Times (Jan Strupczewski): “Greece is unlikely to exit the euro, either intentionally or accidentally. But it might be forced to introduce an alternative means of payment, in parallel to the euro, to pay some domestic bills if a reform-for-cash deal with its creditors is not secured soon, several euro zone officials said. Athens has lost access to bond markets and international creditors are not willing to lend it more money until it starts implementing reforms. An official familiar with the matter told Reuters this week that without fresh funds, the government will run out of money by April 20. ‘At some point, when the government has no more euros to pay salaries or bills, it might start issuing IOUs -- a paper saying that its holder would receive an x number of euros at a point in time in the future," one senior euro zone official said. ‘Such IOUs would then quickly start trading in secondary circulation at a deep discount to the real euros and they would become a 'currency', whatever its name would be, that would exist in parallel to the euro,’ the official said.”
All in all, it was another unsettled week for commodities, currencies, equities and fixed-income. 

Ten-year Treasury yields traded at the week’s low yield of 1.85% Wednesday and a high of 2.01% Thursday. Thursday trading saw the yen trade at a one-month high versus the dollar. The two-year German bund traded at a record low negative 0.256% in early-Friday trading. After trading below $45.50 Monday morning, crude (WTI) surged 7% to traded near $52.50 on Thursday. Late-Friday selling saw crude sink 5.6% to end the week up $2.30 to $48.87.

March 27 – Financial Times (Peter Salisbury): “Shia Houthi rebels clashed with Saudi military units on Yemen’s northern border on Friday. The rebels vowed to intensify their campaign for control of the country after a second night of air strikes by a coalition of regional Sunni states led by Saudi Arabia. Houthi fighters also clashed with rival militias in the south of the country. As the fighting intensified, president Abd-Rabbu Hadi, who this week fled the southern port city of Aden in the face of the Houthi advance, travelled to Egypt to attend a summit of Arab leaders in Sharm el-Sheikh. The president vowed to call for an Arab ‘Marshall Plan’ to rebuild his country once the Houthis have been ousted. Tensions grew on Friday as Saudi and Egyptian warships deployed to the strategic Bab al-Mandab strait in an effort to stop Houthis taking control of the waterway. Large volumes of Gulf oil and trade flow through the strait, bound for the Suez Canal.”
For some time now, markets have been content to gaze at a Middle East drifting into the abyss. 

Now, with Saudi Arabia involved in military operations in Yemen the stakes have changed – perhaps significantly. The risk of major regional conflict escalation has risen. And with the Iran nuclear talks coming down to the wire, the Yemen crisis comes at a critical time. 

 This surely raises the level of general uncertainty, a backdrop supportive of king dollar and ongoing EM instability.