Price Instability

by Doug Noland

February 03, 2012



Chairman Bernanke was forthcoming yesterday when he stated that loose monetary policy distorts the economy and leads to inflationary pressures. I’ll contend that the world would today be a safer place if “easy money” in fact always led to inflationary pressures. In reality, some of history’s most notorious Bubbles developed in an atypical environment comprising loose monetary policy and well-anchored consumer price inflation. 


One can look to the seemingly sanguine pricing backdrops in the U.S. during the “Roaring Twenties” and Japan in the eighties as cases in point. In both circumstances, a misdiagnosis of the Credit and financial backdrop was instrumental in policymakers remaining too loose for too long - and unwittingly accommodating precarious Bubble dynamics.

The U.S. economic recovery has achieved some momentum, risk markets are quite strong, the liquidity backdrop is amazingly robust, the banking system stable – and the Fed has nonetheless committed to sticking with near-zero rates for at least several more years. To be sure, market participants are anything but oblivious to the fact that they enjoy both ultra-loose liquidity conditions and a Federal Reserve eager to implement additional quantitative easing in the event of renewed economic weakness or market stress. It makes the old “Greenspan put” rather child’s playish.



In such a speculative marketplace, bubbling risk markets provide a powerful incentive that forces believers and non-believers alike to hop aboard. Increasingly, it’s a marketplace where everyone is being forced to become a trader with a short-term performance and trend-following focus. Attention to risk is proving too excruciating. For this phase of a historic Bubble cycle, it has been more a case of the Federal Reserve inciting rather than just accommodating Bubble Dynamics.



The Fed and global policymakers have fashioned a decidedly unlevel playing field. A distorted market incentive structure has fomented yet another bout of self-reinforcing risk-taking and speculation. Not all that many weeks ago, the global financial system was being rocked by de-risking and de-leveraging dynamics. Leveraged long positions were being reversed, which – in global markets dominated by leveraged speculation – was quickly leading to serious market liquidity issues. At the same time, markets were inundated with derivative-related selling, as players across the globe implemented strategies to hedge against various risk scenarios. With increasingly illiquid markets unable to withstand such selling pressure, global policymakers responded with resolve.



There is no happy medium. Equilibrium is a myth. It’s risk on or risk off – melt-up or melt-down. Oddly, relatively risk-averse and hedged global markets create quite a tinderbox. And as we now watch global risk markets catch fire and demonstrate a captivating propensity for going into melt-up mode, we’re witnessing confirmation of the “bi-polar,” “bimodal” and “fat (left and right) tail” thesis. There are reasons why speculative Bubbles tend to end with destabilizing “blow-off” tops.



It is understandable to be confused by such strong market performance in the face of major global structural issues and attendant risks. I would argue that markets have turned highly speculative specifically because of the deep structural issues confronting global policymakers. 


Last year, the efficacy of policy measures notably dissipated (in Europe and here with QE2), provoking only more aggressive policy interventions. The markets are now responding to the unprecedented liquidity backdrop – and the reality that global policymakers have become hostage to the markets. Risk concerns have evaporated, and ebullient traders are referring to “the sweet spot.”



Not for a minute have I ever believed that the proliferation of derivative trading would end well. When a meaningful part of the marketplace moves to implement hedging strategies (as was the case again last year), the market will immediately find itself both prone to illiquidity and vulnerable to trend-following selling pressure. And, as we’ve seen, when policymakers then aggressively intervene to stem deepening market stress, markets abruptly become susceptible to a destabilizing reversal of hedging-related exposures. The unwind of both hedges and bearish short positions creates a powerful burst of buying power and marketplace liquidity. In short order, dangerously illiquid markets can be transformed into abundantly – I would argue, overly – liquid. And there is nothing like the specter of buying panic associated with a major short squeeze to really empower the markets’ animal spirits. Nervousness and risk aversion are so second-half 2011.



The NYSE Financial Index is already up 13.6% year-to-date. Bank of America has gained 41%, Citigroup 27%, and JPMorgan 15%. Morgan Stanley and Goldman Sachs have jumped 34% and 30%, respectively. The S&P500 Homebuilding index has a 2012 gain of 20.9%. The Morgan Stanley Cyclical index is up 16.0%. The small cap Russell 2000 has gained 12.2% and the S&P400 MidCap Index has jumped 10.5%. The Morgan Stanley High Tech index is already up 14.0%, and the Nasdaq100 closed today at the highest level since early-2001.



It’s a backdrop that had me this week recalling the 1990s. I certainly haven’t heard so much bullish technology chatter since the tech Bubble. The outperformance of heavily shorted stocks also brings back memories of the nineties’ squeezes and all the trading fun and games. In the nineties, liquidity and market distortions were being fueled by the explosion of Wall Street debt instruments and leveraged speculation. The GSEs (chiefly Fannie, Freddie and the FHLB) were there to covertly provide a powerful liquidity backstop in the event of heightened market stress. 


The market incentive structure was pro-Bubble, and especially toward the end of the decade the marketplace had become rather emboldened from repeated crises resolutions. Today, the distortions are fueled largely by an explosion of Treasury debt and speculative leveraging, with the Fed and global central banks acting conspicuously as market liquidity backstops. Players are again emboldened.



I’ve been at this for awhile, so you won’t hear me calling for the imminent demise of this Bubble. I will, however, continue to warn that when this one blows there will be hell to pay. And what a fascinating juncture for the marketplace to so emphatically embrace risk-taking. Especially with readily available derivative risk protection, it is indeed rational for players to aggressively play the (policy-induced) global risk market rally – with one eye on buying cheap risk insurance. And I will assume the sophisticated global speculators will play this for all its worth (multi-billions, literally) – with an eye on the exits in the event Europe begins to unravel. Policymaker efforts to avoid a system blowup have created a backdrop conducive to a destabilizing speculative blow-off. And the Fed can still somehow trumpet “stable prices.”