The Downside of Do Whatever it Takes
by Doug Noland
October 17, 2014
Goldman Sachs CEO Lloyd Blankfein provided a market-calming interview late Thursday afternoon with CNBC’s Carl Quintanilla. Not surprisingly, I suppose, Blankfein praised the Fed for being “wise and courageous.” He also stated that extreme market views were wrong.
Considering the global backdrop, I actually see a curious lack of extreme views (at least from the bear side). Instead, we’re at the stage of the cycle where even “bearish” pundits go out of their way to distance themselves from “the world is ending” prognosis. I guess I would be considered an extremist, though I don’t see the world ending anytime soon. But this week did offer further evidence that history’s greatest financial Bubble is at significant risk.
Friday’s rally did a lot to paper over what was a disturbing week for global markets. The mini-melt-up successfully took a great deal of value out of index and stock put options that expired Friday. Those seeking market protection will now have to pay up for expensive puts that expire in November, December or later.
But don’t let the S&P 500’s modest 1.0% decline fool you. It was an extraordinary week.
Japan’s Nikkei index was hammered for 5.0%, increasing 2014 losses to 10.8%. Japanese two-year yields traded to a record low 0.005%. After beginning the week at 6.60%, Greek 10-year bond yields traded to 9% on Thursday (before closing the week at 8.07%). Wild instability returned to European debt (and equities) markets. Portugal’s 10-year yields were up 75 basis points by Thursday, before a rally cut the week’s jumpe to 35 bps. Germany’s DAX equities index dropped 2.87% on Wednesday then rallied 3.12% on Friday. Italian stocks sank 4.44% and then rallied 3.42%.
Panic buying saw German bund yields trade to a record low 0.71% on Thursday, before ending the week at 86 bps. Spreads to bunds widened meaningfully throughout Europe. The German to Italian spread widened 20 bps to 165 bps, and German to Spanish 13 bps to 131 bps.
Curiously, even French bonds showed some vulnerability this week. With French 10-year yields up 6 bps, the spread to bunds widened nine to a three-month high 44 bps. Notably, Cyprus CDS surged 112 bps this week to an eight-month high 482 bps.
Watching the U.S. long-bond surge a full four points on my Bloomberg screen Wednesday morning brought back memories. I recall staring at Quotron and Telerate screens back on “Black Monday,” October 19, 1987, as stocks crashed and Treasury bonds gained an incredible 11 points. Ten-year yields traded to a low of 1.86% on Wednesday, with two-year yields down to 0.25%. In a matter of several hours, five-year Treasury yields traded from 1.47% down as low as 1.11%. In just seven sessions two-year yields sank from 56 bps to 31 bps. Recent trading has seen wild volatility in eurodollar future, CDS and derivatives markets generally. After beginning the week at 21.24, the VIX (equities volatility) index traded above 31 on Wednesday to the highest level since 2011 (surpassing even 2012 European crisis levels!). It is certainly also worth mentioning that the Goldman Sachs “Most Short” index jumped 3.3% this week in one of the bigger recent outperformances posted by commonly shorted stocks. The S&P 500 Homebuilding Index jumped 7.85% this week.
I find the backdrop surreal. And the more everyone acts as if it’s all business as usual the more worried I become. As crazy as I know it sounds, I am these days reminded of my bewilderment when studying the period leading up to the 1929 stock market crash. How could they not have seen it coming? How could everyone remain so bullish (“a permanently high plateau”) considering what in hindsight was an obvious – and quite ominous – deterioration in the market and global economic outlook. I also think often of a quote from that period: “Everyone was determined to hold their ground, but the ground gave way.” Can the world’s central bankers hold everything up?
These days, there are extraordinary divergences in views – two altogether different worlds – two completely opposing views of how things work. Take off the rose-colored glasses and the world is clearly a scary place. So long as the markets go higher the glasses stay on. Increasingly, however, I suspect many in the hedge fund industry see the markets similarly as I do – in complete disarray. Meanwhile, the traditional long-equities investors see yet another dip to buy before another big rally takes stocks to record highs.
So is this just another “healthy correction” or are there more serious dynamics at work?
For me, this week’s major market instability supported the bursting global Bubble thesis. In a way, the week was akin to a “flash crash” on a global, multi-asset class basis. Aggressive selling found a dearth of willing buyers – stocks, bonds, commodities and derivatives. Panic buying of Treasuries and bunds found a dearth of sellers. In short, various markets dislocated in illiquidity – simultaneously. I assume leverage and derivatives-related trading played integral roles.
Importantly, wild instability across various markets has surely inflicted meaningful losses on the global leveraged speculating community. With many funds now posting negative returns for the year coupled with markets succumbing to treacherous volatility, a period of de-risking/de-leveraging is likely now at hand. But as we saw this week with many stocks (and sectors) that the speculators were short, market dislocation and short squeezes can fuel spectacular volatility and even big gains.
Rather 1929esque, Jeremy Siegel filled the airways trumpeting robust U.S. fundamentals and Dow 18,000 (by year end!). Meanwhile, The Wall Street Journal went with the headline “Corporate-Debt Market Slows to a Crawl.” “Crawl” was generous. Bloomberg hit the mark: "Credit Markets Weaken as New Issuance Halts, Junk Extends Losses.” Importantly, the corporate debt market – especially for high yield bonds and loans that have been issued in record quantities – basically shut down this week.
To be sure, the U.S. Bubble economy will be at risk if this key financing market doesn’t get back to business quickly. M&A would be at risk; stock buybacks at risk; and corporate earnings and spending would be at risk.
While it has garnered some boom-time momentum of late, I believe the U.S. economy is more vulnerable than most appreciate.
Another Bloomberg headline: “Oil and Junk Don’t Mix as 19% Rout Posted on Worst of Crude Debt.” The U.S. energy revolution has been integral to the bull story on the U.S. economy. Now, with crude prices having collapsed, we’ll begin to tally the damage from one of the more conspicuous Fed policy-induced Bubbles. There are as well plenty more commodity price downturns (corn, wheat, soybeans, cotton, etc.) that will surely unveil plenty of ill-advised lending and investment. And I certainly expect many U.S. companies to suffer at the hands of a weakening global economy.
I subscribe to the “Austrian” focus on the critical importance of a balanced economic expansion. But in our world of central bank policy-induced financial booms and busts, economic balance is relegated to history. Instead, we live in a world of intractable imbalances and destabilizing serial sector Bubbles. The Tech Bubble, the “housing” Bubble and more recently the energy Bubble, Tech Bubble 2.0 and Stock Market Bubble 3.0. After years of excess and resulting resource misallocation, the maladjusted U.S. economy is inherently vulnerable to a reversal of speculative finance and resulting tightening of financial conditions (with deflating U.S. securities prices).
From my perspective, global markets have begun to adjust to what will be momentous changes to the financial and economic landscape. Faltering global fundamentals ensure acute problems for an over-leveraged world. Collapsing commodities prices equate to debt problems for scores of companies, countries, lenders and speculators. And considering the scope of global leverage and speculation, the odds of this market adjustment spiraling into a major financial crisis are high. This week offered unmistakable evidence as to how quickly things can unravel. In powerful crannies in the marketplace, confidence likely took a forceful hit this week. Potential illiquidity became a pressing issue.
At about 10:20 a.m. on Thursday, with European markets tanking and U.S. equities sinking, St. Louis Fed president James Bullard began to be interviewed on Bloomberg Television. Bullard, generally considered a FOMC moderate, had more recently shifted to the hawkish contingent. This ensured that his Thursday morning flutter to join the doves provided notable relief to the markets. The key Bloomberg headline (10:25 am): “Bullard Says Fed Should Consider Delay in Ending QE.” Nervous markets had been awaiting a signal of support from the FOMC. From the market’s 10:18 a.m. low to Friday’s high the S&P500 rallied 3.4%.
San Francisco Fed chief John Williams actually got things going Wednesday with his comment (Reuters interview), “If we really get a sustained, disinflationary forecast ... then I think moving back to additional asset purchases in a situation like that should be something we should seriously consider.” It was close enough to Bernanke’s summer of 2013 assurances that the Fed would “push back” against a tightening of financial conditions. As a longtime close advisor to Janet Yellen, Williams’ views matter to the markets.
The QE issue is a fascinating one. History is rather clear: once major monetary inflations begin they become nearly impossible to stop. I certainly don’t expect the ballooning of the Fed’s balance sheet stops at $4.5 TN. There will be no “exit.” I’m thinking “QE4” might be ushered in with something similar to the Fed’s statement before the stock market opened the day following the 1987 crash: “The Federal Reserve, consistent with its responsibilities as the Nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”
The bulls absolutely fixate on the Fed (and its cohorts) reliably backstopping the markets – “QE infinity”. I could only chuckle when reading a Wednesday UK Telegraph headline: “World Economy So Damaged It May Need Permanent QE.” Anyone asking how it became so damaged?
From a real world perspective, by now it’s apparent that QE doesn’t work as prescribed – as the propaganda asserts. Global central banks have added Trillions of liquidity and the global economy and markets are as fragile as ever. The Fed has “printed” almost $3.6 TN in six years and the U.S. economy remains extraordinarily vulnerable. Arguably, U.S. securities Bubbles are an accident in the making. Incredible QE in Japan has had only modest economic impact, with sinking stocks now weighing on confidence. In the past two years of incredible global monetary pumping, disinflationary forces have gathered momentum. Many commodities are trading at multi-year lows. Now global market participants and pundits clamor for aggressive ECB QE, while blasting what is commonly viewed as mindless German austerity. The hope has been that ECB QE would sustain the global Bubble. Mindfully, the Germans don’t want to play ball.
If only Bubbles lasted forever. And, unfortunately, the longer they persist and the bigger they inflate -the more problematic the unavoidable collapse. This important reality is ignored at everyone’s peril. Determination to avoid collapse only ensures greater and more precarious Bubble distortions and maladjustment. “World Braces as Deflation Tremors Hit Eurozone Bond Markets,” read another UK Telegraph headline. And Bullard and the global central bank community fret a “collapse in inflation expectations.” It is important to recognize that disinflation and collapsing “inflation expectations” are symptomatic of a bursting global financial Bubble, providing early evidence of what will be a spectacular failure in experimental “activist” central banking.
Predictably, the calls for more “money” printing turn boisterous and increasingly desperate. But more QE only delays the day of reckoning. I guess I am an “extremist” for stating that printing “money” out of thin air and inflating global securities markets are not going to resolve deep structural deficiencies in global Credit and economic “systems.”
So how long can global policymakers and bullish pundits keep the Bubble psychology alive?
Indeed, we’re now facing two radically different world backdrops: the historic Bubble regains some momentum - or it continues to deflate.
These quite contrasting worlds imply widely divergent market values for so many things around the world, certainly including securities prices. So long as confidence holds, many will argue that securities are attractively valued. But if markets continue to weaken, financial conditions further tighten and liquidity continues to wane (i.e. contagious de-risking/de-leveraging), then securities markets will face a very problematic period of instability and revaluation.
I’ll state it again, I find the current global backdrop much more problematic than 2007/08.
Having become a historic Bubble, China’s financial system and economy are incredibly more fragile than six years ago. Throughout the emerging markets, economies and Credit systems have been damaged by six years of reckless excess. And how about Europe – financial systems, economies, societies and geopolitics? Across the board, European fundamentals have suffered frightening deterioration. And I can only concur with comments repeated Friday by Bundesbank President Weidmann: “ECB’s QE will not fix the Eurozone’s problems.”
This week saw some of the problems associated with aggressive central banking come home to roost. In a serious crack at the “periphery,” Greek bond yields spiked 250 basis points in three sessions. In the halcyon world of endless cheap liquidity, Greece’s debt load appeared manageable. So why not leverage in higher-yielding Greek debt with Fed, BOJ and Draghi all backstopping the markets? Why not debt from Portugal, Italy, Spain and France? Why not all higher-yielding “periphery” debt, including European and U.S. junk bonds? What difference do fundamentals matter when central bankers are promising to do “Whatever it Takes.”
Meanwhile, two years of booming securities markets took the heat off of European politicians (just as the Germans warned!). France is in the process of (again) flouting EU deficit rules, while Italy has also decided to boost deficit spending (with debt-to-GDP above 130%!). For monetary integration to have any chance of success would require strict fiscal integration. Things are instead going in the opposite direction, and there’s going to be some heated battles ahead. As I’ve said in the past, at the end of the day I do not expect the Italians (or the Greeks or French) and the Germans to share the same currency.
October 16 – Bloomberg (Patrick Donahue and Ilya Arkhipov): “Talks between Vladimir Putin and German Chancellor Angela Merkel, who blamed Russia for stoking the crisis in Ukraine, were scrapped when the Russian leader overstayed a celebration of a Soviet defeat of the Nazis in Serbia. Serbia’s government, which has refused to implement European Union sanctions against Russia even as it’s trying to join the bloc, welcomed Putin with the country’s first military parade since the days of Cold-War President Josip Broz Tito.”
I expect the markets will be confronted by myriad troubling European issues.
From the markets’ perspective, the Ukraine crisis has been resolved. Putin buckled under the pressure of Western economic sanctions, in another win for contemporary finance. I suspect this thinking is way too optimistic. Actually, I believe Putin is determined that Western sanctions don't win. And there were some rather ominous warnings this week regarding the potential consequences of “blackmailing” Russia. So don’t be surprised if Putin turns the tables and blackmails the West (i.e. if sanctions are not lifted there will be a renewed land grab in Ukraine, along with a more belligerent stance generally).
And while the focus was more on market volatility and the Ebola virus, the geopolitical backdrop worsens by the week. Putin and Beijing seem to be singing from the same hymnbook, as the Chinese turned more outspoken in blaming the U.S. for the Hong Kong protests (and other “color revolutions”). The situation in the Middle East becomes more alarming by the week. Overall, the gap between disconcerting global prospects and ebullient securities prices is as wide as ever.
Clearly, central bankers would hope to maintain this gap – to defend the Truman Show World. And I don’t believe it is an extremist view to see this as one big financial scheme. Moreover, it’s not extremist to fear how things will play out when confidence wanes - when this scheme falters.
Actually, the extremists are the inflationists that believe printing money will resolve the world’s ills. The Fed has been neither “wise” nor “courageous.”
Have we not seen enough already?