Memories - of 2012 and 2007by Doug Noland
November 21, 2014
November 21 – Reuters (John O'Donnell and Eva Taylor): “European Central Bank President Mario Draghi threw the door wide open on Friday for more dramatic action to rescue the euro zone economy, saying ‘excessively low’ inflation had to be raised quickly by whatever means necessary… ‘We will continue to meet our responsibility – we will do what we must to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us,’ Draghi said… ‘If on its current trajectory our policy is not effective enough to achieve this, or further risks to the inflation outlook materialise, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases.’ ‘Draghi all but announced that the central bank will step up monetary easing soon. Mr Maybe has become Mr Definitely,’ said Nick Kounis, an economist with ABN Amro. …Draghi's remarks were almost as dramatic as his ‘whatever it takes’ speech in the summer of 2012 with which he pulled the euro zone back from the brink. Having earlier in the week pointed to early signs of improvements, Draghi on Friday said the economic situation remained difficult and the latest business survey suggested a stronger recovery was unlikely in the coming months.”
November 21 – Bloomberg: “China cut benchmark interest rates for the first time since July 2012 as leaders step up support for the world’s second-largest economy… The one-year lending rate was reduced by 0.4 percentage point to 5.6%, while the one-year deposit rate was lowered by 0.25 percentage point to 2.75%, effective tomorrow… The reduction puts China on the side of the European Central Bank and Bank of Japan in deploying fresh stimulus and contrasts with the Federal Reserve, which has stopped its quantitative easing program. Until today, the PBOC had focused on selective monetary easing and liquidity injections as China heads for its slowest full-year growth since 1990… ‘This interest rates adjustment is a neutral operation and doesn’t mean any change in monetary policy direction,’ the central bank said… As China is still able to keep medium to high growth rates, it ‘has no need to take strong stimulus measures, and the direction of prudent monetary policy won’t change,’ the central bank said.”
In a global financial backdrop I view as the most fragile since 2012, we’ve now seen 2012-style aggressive concerted central bank stimulus measures. It will be imperative to closely monitor the various effects. One of these days, such measures will not have their desired impact. We might be getting close.
Last week I dove into somewhat theoretical “Financial Sphere vs. Real Economy Sphere” analysis. I also often fall back on the “Periphery vs. Core” framework that has been informative in an era of highly speculative markets. So after Friday’s moves by Draghi and the PBOC, let’s this week meld some analysis and segue from the more theoretical to the real.
While the policy responses are similar, there are notable differences between now and the 2012 backdrop. Importantly, following a two-year period of QE-induced “parabolic” global securities market inflation, I am arguing that the global Bubble now has serious cracks (irrespective of monetary stimulus). The S&P500 is at record highs, up almost 64% from June 2012 lows. U.S. investor bullishness is at extreme levels. Those believing policymakers have everything well under control have been repeatedly emboldened. The notion of Bubbles – worse yet, bursting Bubbles – is viewed with contempt and ridicule.
It’s worth noting that the Goldman Sachs Commodities Index is off 28% from 2012 highs, with crude down 30%. Commodities and energy complexes have been crushed, portending serious issues for scores of heavily indebted companies, industries and economies. From early-March 2012 levels, the Russian ruble is down 36%, the Brazilian real 32%, the Argentine peso 49%, the Venezuelan bolivar 32%, the South African rand 31%, the Indonesian rupiah 25%, the Turkish lira 20% and the Indian rupee 20%. I contend the (“Periphery”) EM Bubble has begun deflating, with notable fragility emerging from the likes of Russia, Brazil, Venezuela and others. I expect ongoing contagion.
The global Bubble has entered a particularly unstable phase. Desperate policy measures are exacerbating liquidity and speculative excesses. Not surprisingly, monetary stimulus has it greatest impact where Bubble dynamics retain strong inflationary biases – notably U.S. securities markets, but also stocks, corporate debt and sovereign bonds around the globe.
The Treasury reported its monthly TIC (Treasury International Capital) data this past Tuesday. September saw a record $164bn inflow into U.S. “Net Long-Term Portfolio Securities.” I was reminded of the then record $136bn inflow in May 2007. With faltering Bubbles and “hot money” again on the move, we don’t have to look that far back for an insightful example of how aggressive monetary measures (responding to a faltering Bubble) fueled precarious “Terminal Phase” excess.
It’s especially instructive to recall how Bubble Dynamics played out in that fateful 2007/2008 period. The Fed’s Z.1 “flow of funds” data do a nice job. The mortgage finance Bubble was initially pierced in the spring of 2007, as losses on subprime securities initiated a self-reinforcing reversal of “hot money” flows, a tightening of mortgage Credit and waning home price inflation. The Fed slashed the discount rate 50 bps in an unscheduled meeting in August 2007.
Confident that Bernanke was ready with aggressive “helicopter” monetary stimulus, market participant were happy (gross understatement) to disregard ominous fundamental developments and focus instead on lucrative securities speculation.
First of all, the faltering Bubble was readily apparent in rapidly slowing household mortgage borrowings. After expanding at double-digit annual rates from 2001 through 2006, the home mortgage slowdown was apparent by early 2007. The rate of Household mortgage Credit growth slowed to 7.4% in Q1 2007 and was down to 5.0% by Q4.
In nominal dollars, Home mortgage debt expanded $1.080 TN in 2006. Indicative of a faltering Bubble, Q1 2007 saw Home mortgage growth slow to SAAR $831bn, Q2 to SAAR $808bn, Q3 to SAAR $536bn and Q4 to SAAR $648bn. With multi-family and commercial mortgage Credit growth still brisk, total system mortgage Credit growth remained enormous. After expanding $1.416 TN in 2006 (close to 2005’s record), growth slowed to SAAR $1.120 TN in Q1 ‘07, $1.222 TN in Q2, $999bn in Q3 and $992bn in Q4 (compared to 1990’s avg. $265bn).
It’s worth noting that air was also attempting to come out of highly speculative securities markets in 2007. There was a bout of stock market selling during the first quarter and then a much more significant downturn late in the summer, as the scope of systemic fragility began to be better appreciated. Indeed, a necessary de-leveraging had commenced – only to be reversed by Fed stimulus measures.
After expanding $326bn in 2005, $406bn in 2006 and a seasonally-adjusted and annualized (SAAR) $726bn in Q1 2007, the growth in “Fed Funds & Security Repo” (used for securities leveraging) began slowing sharply. Q2 saw growth drop to SAAR $181bn, before turning negative in Q3 (SAAR -$142bn) and Q4 (SAAR -$797bn). After “Security Brokers/Dealers” expanded holdings a record $615bn in 2006 (double 2005 growth!), holdings grew another SAAR $1.145 TN in Q1 and SAAR $826bn in Q2. Security Brokers/Dealers ballooning hit the wall in Q3 (SAAR $42bn) before contracting in Q4 (SAAR -$625bn). Some beneficial de-risking was also apparent in Security Credit. After record expansions in 2005 and 2006, Security Credit contracted slightly during Q3 2007.
I am convinced that desperate policy responses to bursting Bubbles only make things worse.
It’s interesting to recall how the policy response (actual and anticipated) to the faltering mortgage finance Bubble fueled dangerous “Terminal Phase” (“still dancing”) excess throughout corporate finance (issuance, junk, M&A, financial engineering, etc.). Nowhere, however, was the “Periphery vs. Core” Bubble Dynamic more apparent than in the securitization marketplace. After almost doubling between 2003 and 2006, the (largely subprime mortgage) ABS market began to falter in 2007. Following 2006’s record $808bn expansion, ABS growth slowed to SAAR $205bn by Q2 2007 and actually began a painful contraction in Q4. Importantly, serious issues at the “Periphery” of mortgage Credit initially spurred (as market yields sank) rampant “Terminal Phase” excess at the Bubble’s “Core”. In the six quarters Q1 ’07 through Q2 ’08, GSE MBS expanded $924bn, or 24%. Total GSE Securities (MBS and debt) over this 18-month period expanded $1.400 TN, or 21.6%. I believe strongly that this central bank-incited (late-cycle) excess at the “Core” significantly contributed to the severity of the 2008/09 crisis.
Thinking in terms of “Financial Sphere Bubble” analysis, it should be noted that Financial Sector market borrowings expanded 10.0% in 2006, up from 2005’s 9.0%. Subprime and ABS issues were behind a marked slowdown in Financial Sector borrowings during 2007’s first-half. Yet with monetary policy poised to shift into overdrive, the Financial Sector expanded at a blistering 15.8% rate during Q3 2007, powered by the invigorated “Core” (GSEs, MBS and Corporate Bonds).
Credit growth could have – should have – slowed markedly during 2007. Instead, fueled by record “Core” (Terminal Phase) expansion, total system Credit expanded at an unprecedented rate – right in the face of a faltering mortgage Finance Bubble! Total Non-Financial Credit expanded a record $2.540 TN in 2007 (‘90’s avg. $720bn), while Financial Sector market borrowings grew a record $1.795 TN (90’s avg. $497bn). There was, however, a momentous problem: the Credit Bubble was unsustainable. When the overheated “Core” eventually succumbed to the forces of Bubble collapse, the system’s highly inflated price levels (throughout the Financial and Real Economy Spheres) created extreme systemic fragilities. Key risk intermediation processes were discredited (GSEs, CMOs, highly leveraged securities holdings, etc.), which ensured a collapse in private-sector Credit growth.
What pertinent lessons can be drawn from the 2007/2008 experience? First of all, policy measures that extend the life of “Terminal Phase” excess can prove catastrophic. In particular, heavy Financial Sector risk intermediation (2007: GSE, MBS, CMO) play a critical role late in the Bubble cycle, ensuring ongoing Credit expansion – hence prolonging the boom cycle. This capacity to transform high-risk Credit, market and liquidity risks into perceived “money-like” instruments seems virtually miraculous. Moreover, this process is instrumental in nurturing problematic euphoria and complacency. And as things tend to regress into late-cycle craziness, leveraged speculation and “hot money” come to play a decisive role throughout increasingly unstable markets.
Indeed, the stage had been set for very serious problems. When the down cycle’s contagion eventually arrived at the “Core,” key intermediation processes faltered – leaving a highly inflated system extremely vulnerable to a crisis of confidence and Credit collapse. Importantly, when it comes to Bubbles, the sooner they come to an end the better. Systemic risk grows exponentially, a harsh reality that central bankers refuse to acknowledge.
The scope of today’s “global government finance Bubble” dwarfs the 2007’s mortgage finance Bubble. There’s a lot more to lose in this international Bubble and so much more to worry about. Instead of “subprime,” today’s “Periphery” includes tens of Trillions of vulnerable debt encompassing many countries and billions of people. Instead of U.S. prime mortgages and corporate debt, today’s “Core” includes central bank Credit and the greatest securities Bubble the world has ever experienced.
At the “Core of the Core,” historic market euphoria has pushed excess in U.S. equities and corporate Credit to precarious extremes (relative to rapidly deteriorating global financial and economic fundamentals). Concerted global central bank stimulus measures have exacerbated the divergence between inflated securities prices and deflating prospects for global growth and profits. Worse yet, the redistribution of wealth that accompanies the policy-induced inflation of the “Global Financial Sphere” is worsening already alarming geopolitical tensions. Global central banking and “risk free” government debt are at risk of being discredited.
Why would I contemplate that central bank measures might be losing ability to keep the global Bubble afloat? Over recent weeks we’ve seen the concerted efforts of team Yellen, Draghi, Kuroda and the PBOC have minimal impact on the fragile “Periphery.” Even Friday, on the back of Draghi and the Chinese, crude oil gave back much of an earlier 2.6% gain to close the week up only 69 cents. The Goldman Sachs Commodities index was only slightly positive for the week near multi-year lows. Curiously, Italian CDS increased added a basis point this week.
The Mexican peso declined 60 bps this week, trading at the lowest level versus the dollar since the summer of 2012. Mexico succumbing to EM contagion would be a major development.