FAULT LINES / PRUDENTBEAR.COM

Fault Lines

April 19, 2013

by Doug Noland


More pressure on commodities, commodity currencies, commodity economies and equities.

Yet another fascinating week - and one more week of anecdotes confirming the global Bubble thesis.

I have vivid memories of reading a Financial Times article back from early-1998 that detailed the massive growth in ruble derivative transactions written by the Russian Banks. Russia was front and center in my macro analysis back then. While reading the article, I recall exclaiming “I think they’ve blown themselves up.”

I saw Russia as an increasingly fragile Bubble at the time, having become acutely vulnerable to huge “hot money” outflows and Credit collapse after the catastrophic financial and economic crisis wreaked bloody havoc throughout South East Asia in 1997. Yet, a complacent market view was taking hold that the IMF and global central banks had things well under control. No way would the West ever allow a Russian collapse, or so they thought. I saw the huge build up in ruble derivatives as a likely Fault Line. If Russia succumbed, the ruble would tumble, its banks would be on the hook for unmanageable derivative losses and the sovereign would face potential meltdown. The leveraged speculators were big in Russia at the time.

I believe it was in early-2007, when my focus was squarely on an increasingly vulnerable mortgage finance Bubble. The Financial Times’ Gretchen Morgenson began writing about the $1 TN of subprime CDOs (collateralized debt obligations) that Wall Street had created during 1996. And I remember thinking, “Unbelievable, this is even worse than I suspected.” Subprime derivatives had created another historic financial Fault Line.

Memories of previous Fault Lines were jogged this week by a bevy of informative Financial Times articles (touching upon what I consider key potential Fault Lines). First, there was an article by Michael Stothard, “Naked CDS Ban Fuels Bank Funding Fears.” “It’s called the law of unintended consequences. Last November, European regulators were fed up with hedge funds using the derivatives market to bet against sovereigns so they imposed a ban on outright speculation… Six months on from the ban on buying naked sovereign CDS protection – where the investor does not own the underlying government bond – it is clear that negative bets against large financials have emerged as a partial replacement… In the first quarter volumes fell 35% to $168bn from the fourth quarter of last year, according to the DTCC, the swaps data warehouse. In the same period the volumes traded on the iTraxx Senior Financial index, one of the most liquid European indices encompassing some of the largest banks in the region, have nearly doubled from $252bn to $400bn, according to the DTCC.”

And there was “China Local Authority Debt ‘Out of Control,’” by the Financial Times’ Simon Rabinovitch: “A senior Chinese auditor has warned that local government debt is ‘out of control’ and could spark a bigger financial crisis than the US housing market crash. Zhang Ke said his accounting firm, ShineWing, had all but stopped signing off on bond sales by local governments as a result. ‘We audited some local government bond issues and found them very dangerous, so we pulled out,’ said Mr Zhang, who is also vice-chairman of China’s accounting association. ‘Most don’t have strong debt servicing abilities.

Things could become very serious.’ ...Mr Zhang said many local governments had invested in projects from public squares to road repairs that were generating lacklustre returns, and so were relying on financing rollovers to pay back their creditors. ‘The only thing you can do is issue new debt to repay the old… But there will be some day down the line when this can’t go on.’ Mr Zhang added that he grew alarmed when smaller towns and counties discovered that investment vehicle bonds were an easy way to raise financing. ‘This evolution was quite frightening,’ he said.”

And the third of the Fault Line Trifecta, “Japanese Easing Plays Havoc with JGBs,” by Ben McLannahan of the Financial Times: “So much for Haruhiko Kuroda’s plans to ease the flow of credit. Since the new governor of the Bank of Japan shouldered his ‘big bazooka’ two weeks ago, promising to buy up more government bonds than ever to drive down the cost of borrowing, yields have risen at every point along the country’s 30-year sovereign debt curve, prompting some banks to charge more for loans. At the same time, trading volumes in Japanese government bonds – or JGBs – have collapsed, sending volatility to record highs and threatening the ability of the world’s most indebted government to keep funding itself at the world’s lowest rates. An auction last week of 30-year bonds was ‘horrendous’, in the words of one strategist… Net annual asset purchases by the BoJ have risen to nearly 15% of nominal gross domestic product, notes Nomura, making Mr Kuroda’s ‘new phase’ of easing significantly bigger than any equivalent operation around the world… Amid the ‘shock and awe’ of this radical policy shift, investors in Japan’s Y914tn ($9.4tn) government bond market, the world’s second-largest, have ‘lost their bearings’, says Naka Matsuzawa, chief Japan rates strategist at Nomura in Tokyo… ‘For now, the easing programme that was announced with such fanfare must be judged a failure,’ says Jun Ishii, chief fixed-income strategist at Mitsubishi UFJ Morgan Stanley Securities.”

Unfettered global Credit coupled with government fiscal and monetary excess has been inflating major Bubbles going back to Japan’s runaway 1980’s Credit Bubble. Japanese and global policymakers have recently resorted to unmatched and untested stimulus measures with unknown consequences. And, today, mounting Bubble fragility can be discerned from all corners of the globe. Never have I seen a backdrop with Multiple Major Fault Lines.

Many profess – and it sounds pretty appealing in theory - that a moderate amount of fiscal and monetary stimulus helps grease the “post-Bubble” economic wheels. Yet inflationary cycles over time have a way of casually drifting way beyond the moderate. In reality, supposed “post-Bubble” reflations actually work predictably to inflate only bigger Bubbles. I would argue strongly that at some point along the way excessive amounts of stimulus begin fomenting exponential growth in latent instability. And I’ll add that once every few generations such dynamics become global in nature.

Today, such instability is on conspicuous display – particularly in Europe, Japan and China. Here at home, it remains for now more latent, masked by huge deficit spending, zero rates and after significant portions of US credit risk have been nationalized with federal guarantees (e.g. residential mortgage, student lending). And the more aggressive the stimulus the more various parties will try to position for competitive advantage. This sets the stage for inevitable instability, conflict and upheaval.

It’s an especially inopportune time for a speculative Bubble in European financial CDS/insurance. With French and German economies succumbing to recession, the region’s already troubled banking system remains susceptible to further asset quality deterioration. In Germany, in particular, I fear several years of ultra-low rates and financial inflows have nurtured unappreciated Bubble fragilities (DAX down 3.7% this week!). Meanwhile, the Draghi OMT backstop has incentivized the speculators back into the region’s financial markets (including higher yielding Eastern European debt). Bank debt and related derivative insurance markets appear to be a focus of speculative activities.

In my old “booming town along the river” analogy, the speculative Bubble in flood insurance worked miraculously – that is until torrential rains incited a panic to reinsure and offload risk that ended in market illiquidity and failure. The European financial sector has a plethora of unresolved issues – economic, financial, regulatory and political. Will the euro even survive? How will the costs of future bailouts be divided? What about the German and northern countries’ move to have bank investors and large depositors contribute to bailouts? It’s a troubling backdrop. Meanwhile, Draghi and global central bank measures have only further distorted markets and boosted speculative excess. When greed turns to fear and Europe’s markets again fall under duress, I’ll be carefully monitoring the functioning of bank and financial CDS markets. I worry about illiquidity.

China is a historic Bubble in the midst of what I refer to as the “terminal phase of blow-off excess.” Previous CBBs have noted the explosion in Chinese Credit since the 2008 global financial crisis. Enormous (and un-quantified) amounts of local government obligations – perhaps significant amounts intermediated through China’s ballooning “shadow banking” system – appear a systemic weak link. Apparently, much of this potentially problematic debt is integral to a historic real estate Bubble. It is, then, noteworthy that a top Chinese accountant warned this week that local debt is “out of control.”

Perhaps Chinese authorities do today have things under control. They may even have yet another big stimulus program ready to implement on command. But I suspect the popular view is too complacent. Actually, I believe the Chinese missed the timing for reigning in Bubble excess before it was too late – by a number of years. As an analyst of Credit, financial and economic Bubbles, things just don’t get more fascinating – or any more intriguing. Historic Credit expansion, historic inflationary manifestations (runaway asset Bubbles, wealth inequalities, price distortions, corruption, environmental degradation, etc.), historic risk intermediation, historic economic imbalances – and a general sanguine view domestically and internationally that the central planners can successfully manage their way through it all. Wow.

Deflation risk continues to garner considerable attention. Some have argued that Japan’s “beggar they neighbor” yen devaluation policy is imposing deflationary pressures upon its neighbors/competitors. Others would argue that the ECB needs to join the “money” printers to spur Europe out of the doldrums. I tend to view global finance and economies as extraordinarily complex systems. From my perspective, a confluence of recent factors has placed global reflation dynamics in heightened jeopardy.

Basically, highly inflated and correlated securities markets worsen global economic and financial fragility. In this regard, I would contend the confluence of Draghi’s “bazooka”, incredible QE from the Fed and BOJ, general global monetary largess, and the Chinese accommodating a runaway Credit expansion has actually only further destabilized global markets and economies. Global policy efforts have further weakened key global Fault Lines.

During the Great Depression, contemporary economic thinkers debated whether it was previous over-investment or mal-investment that was most responsible for deflation. Others pinpointed boom-time speculative shenanigans as a leading culprit that set the stage for bursting Bubbles, price collapses and financial ruin. The “Austrians” distinguished themselves for their keen understanding of how boom-time Credit excess had distorted patterns in both spending and investment – ensuring inevitable economic adjustment and hardship.

Over the years, I’ve highlighted the thinking of the old codgers (including Andrew Mellon) in the late-twenties that had witnessed enough boom and bust cycles during their lifetimes to confidently warn of impending collapse. They were convinced that attempts by our central bank to sustain a protracted inflationary boom (that commenced with the “Great War”) would risk destroying both the economy and the Credit system. These are Dr. Bernanke’s disdained “Bubble poppers.”

Well, we’ve been witnessing similar dynamics in real time. The more “money” central banks inject into the global system, the more this liquidity inflates and distorts securities markets. The greater the stimulus employed to combat deflation risk, the more the over- and mal-investment, especially in China and Asia. The more aggressively activist central banks work to inflate liquidity and market levels, the more encompassing the pool of global speculative finance working to profit from desperate policy measures. The more intensively policymakers in the U.S., Europe, Japan, China and elsewhere work to sustain (“terminal”) late-cycle global Credit excess, the more prominent the inequitable redistribution of wealth to a relatively small group of beneficiaries. We’re deeply into the phase where massive liquidity injections receive little real economy bang for the buck.

From this perspective, global policymakers are fighting like crazy in a battle they cannot win. And perhaps that’s what the markets are just beginning to indicate. Maybe, in what would be a shock to us all, global “reflation” is actually more a lost cause. Further pumping of asset Bubbles only sets the stage for bigger pops. And could air leaking out of the global commodities trade prove the first crack in the global Bubble? The commodities bull market has certainly attracted huge speculative activity, as well as having evolved into a major economic force for thousands of companies and scores of economies around the globe. Along the way, commodities players – speculators, companies and countries – have used a lot of leverage.

The true scope of borrowings and leverage employed all along the commodities/resources chain is unknown. We can safely assume it has been considerable. Hence, there is potential for commodities-related de-risking and de-leveraging dynamics to be impactful for global liquidity and risk-taking more generally. And it’s the nature of Bubble dynamics that deterioration in the liquidity backdrop for one segment tends over time to impede liquidity for another segment – and then another. We already know Europe is weak, China is overheated and Japan is playing with fire. With this in mind, it’s time to closely monitor a disconcerting number of potential Fault Lines around the globe.