The Unavoidable Peril of Financial Sphere Bubbles
by Doug Noland
December 5, 2014
Let’s begin with a brief update on the worsening travails at the Periphery. The Russian ruble sank another 6.5% this week, increasing y-t-d losses to 37.9%. Russian yields surged higher. Russian (ruble) 10-year yields jumped another 146 bps this week to 12.07%, with a nine-session jump of 188 bps. Russian yields are now up 425 bps in 2014 to the highest level since 2009.
Increasingly, EM contagion is enveloping Latin America. The Mexican peso was hit for 1.6% Friday, boosting this EM darling’s loss for the week to a notable 3.0%. This week saw the Colombian peso hit for 4.3%, the Peruvian new sol 1.1%, the Brazilian real 0.9% and the Chilean peso 0.6%. Venezuela CDS (Credit default swaps) surged 425 bps to a record 2,717 bps. Venezuela CDS traded near 1,000 in August. On the bond front, 10-year yields jumped 30 bps this week in Brazil, 24 bps in Mexico and 24 bps in Colombia. Brazilian stocks were slammed for 5% this week and Mexican equities fell 2.2%.
Eastern European currencies were also under pressure. The Ukrainian kryvnia dropped 2.9%, the Romanian leu 1.5%, the Bulgarian lev 1.3%, the Czech koruna 1.3%, the Hungarian forint 1.1% and the Polish zloty 0.7%. The Turkish lira was hit for 1.9%, as 10-year yields jumped 33 bps to 7.91%. The South African rand dropped 2.6% to a six-year low. In Asia, the Malaysian ringgit dropped 2.5%, the Singapore dollar fell 1.4% and the Indonesian rupiah declined 0.8%.
Declining 1.3%, the Goldman Sachs Commodities Index fell to the low since June 2010. Crude traded to a new five-year low. Sugar fell to a five-year low, with coffee, hogs and cattle prices all hit this week.
And a quick look at the bubbling Core: The Dow 18,000 party hats were ready, although they will have to wait until next week. The S&P500 traded Friday to another all-time record.
Semiconductor (SOX) and Biotech (BTK) year-to-date gains increased to 31.4% and 48.1%, respectively. The week also saw $4.0 Trillion of year-to-date global corporate debt issuance, an all-time record. Italian (1.98%), Spanish (1.83%) and Portuguese (2.75%) yields traded to all-time record lows again this week.
December 4 – Bloomberg (Sree Vidya Bhaktavatsalam): “Bill Gross… recommended that investors reduce risk and prepare for asset prices to stop increasing… Gross… suggested that the creation of more debt by policy makers worldwide to solve the credit crisis will be judged by future generations much like smoking in public or discrimination against gays is viewed by people today… ‘Can a debt crisis be cured with more debt?,’ Gross wrote. ‘I suspect future generations will be asking current policy makers the same thing that many of us now ask about public smoking, or discrimination against gays, or any other wrong turn in the process of being righted… How could they? … How could policymakers have allowed so much debt to be created in the first place, and then failed to regulate their own system accordingly? How could they have thought that money printing and debt creation could create wealth instead of just more and more debt?”
I appreciate Bill Gross’ December commentary, “How Could They?” This period will be really difficult to explain to future generations. It’s rather challenging to explain in real time. I’ll dive deeper into the question, “Can a debt crisis be cured with more debt?”
The problem, as we’ve witnessed in the past, is that debt crises have been “cured.” So I would posit that the dilemma associated with reflations is that they do seem to work for a while – perhaps even for a long while – almost miraculously. This naturally bolsters policymaker self-confidence, market confidence in policymaking and confidence in “Keynesian” governmental management more generally. It becomes too easy for everyone to disregard Bubble risks.
The early-nineties debt crisis that followed late-eighties “decade of greed” excess? Well, inflated away with more debt. The S&L fiasco? Right. Inflated away with a major ramp-up of debt growth in the nineties. The 2001/02 debt crisis after the collapse of late-nineties (“technology Bubble”) excess? Melted away like magic through the great inflation of mortgage Credit. And the debt crisis subsequent to the collapse of the mortgage finance Bubble? Inflated away with protracted “global government finance Bubble” Credit excess.
Agreeing with Mr. Gross, I do believe we’re approaching the end of the reflation “miracle”. To build my case, I’ll focus again on Financial Sphere Versus Real Economy Sphere Analysis. It is fundamental to my Credit Bubble Thesis that the (desperate) global central bank reflationary push is mainly inflating the Financial Sphere. This reflation has unfolded primarily through central bank Credit, sovereign and corporate debt, and global securities markets. Especially over the past two years, there is support for the view that it's only a myth that central banks control and can readily manipulate a general price level (in the real economy).
A Bank of Japan (BOJ) board member, Takehiro Sato, Friday made a pertinent comment (quoted by WSJ): “Prices reflect the temperature of the economy, not a variable that can be directly controlled by a central bank.” Japan’s 25-year experience offers the best proof that even massive government fiscal and monetary stimulus does not ensure the ability to inflate out of debt problems.
Real economy pricing dynamics – especially in contemporary globalized economies – are highly complex. The massive increase in manufacturing capacity associated with globalization has placed downward pressure on many prices. Virtually unlimited cheap finance on a global basis has over recent years certainly spurred unprecedented capital investment.
And, importantly, ongoing technological innovation and the “digital age” have played a momentous role in creating essentially limitless supplies of smart phones, tablets, computers, digital downloads, media and “technology” more generally. Throw in the growth in myriad “services,” including healthcare, and we have economic structures unlike anything in the past.
History will look back and see this as all rather obvious. Today, central bankers ignore the reality that reflationary measures confront insurmountable headwinds in the Real Economy Sphere.
The Bernanke-inspired global central bank experiment is mindlessly fixated on dropping “helicopter money” directly into the Financial Sphere. The expectation has been that rising securities prices and “wealth” creation would feed through to the real economy – in the process spurring borrowing, spending and real investment sufficient to inflate the system out of its debt and structural woes.
“Can a debt crisis be cured with more debt?” Well, I would strongly suggest that if policy-induced debt expansion unfolds predominantly in the realm of the Financial Sphere, there’s a major, major problem. If prevailing effects include rampant speculative leveraging, it will work too well to inflate Bubbles only to later return to haunt system financial and economic stability.
I would further argue that an expansion of non-productive debt, while short-term stimulatory, is also deleterious for financial and economic systems. Trillions of new government borrowings financing consumption – debt expansion unlikely to be reversed - is asking for long-term problems. I also believe strongly that Financial Sphere inflations are essentially wealth redistributions, ensuring that daunting economic and social problems come to create powerful headwinds for real economies.
What differentiates today’s reflation from those that “worked” in the past? The current reflation has overwhelming manifested within the Financial Sphere. And that’s the essence of why I believe the Bubble is now running on borrowed time. It’s a critical issue that goes completely unrecognized these days: In the end, Financial Sphere inflations are unsustainable.
The crucial vulnerability lies within the murky world of Risk Intermediation. Financial Sphere expansions inflate myriad market risks – including price, Credit, interest-rate, liquidity and, more generally, Bubble risks. From my perspective, the global government finance Bubble is in the late stages because of the acute fragility associated with mounting Financial Sphere risks. Especially since the summer of 2012, global central bankers have been in a desperate struggle to sustain Financial Sphere Bubbles. Yet the most significant consequence has been the widening divergence between deteriorating global economic prospects and escalating securities market risks.
Aggressive/reckless Risk Intermediation played a fundamental role throughout the fateful post-tech Bubble reflation. The GSE’s, the securitization marketplace and derivatives were instrumental to the “Wall Street Alchemy” that transformed Trillions of risky mortgage Credit into perceived safe and liquid “money-like” instruments. The “Moneyness of Credit” was essential for the doubling of mortgage Credit in just over six years. It amounted to a historic episode of risk and market distortions. Moreover, as the cycle lengthened and risk escalated, the Risk Intermediation task fell increasingly to the toxic combination of CDO/derivatives markets and leveraged speculation.
Credit, speculation and (financial and economic) resource misallocation facets of the Bubble guaranteed that collapse was unavoidable. The widening gulf between the perception of “moneyness” and the deteriorating quality of the underlying instruments was unsustainable.
Importantly, policy stimulus only prolonged the “Terminal Phase” parabolic rise of systemic risk. Late-cycle Financial Sphere distortions ensured a misallocation of resources in the real economy that came back to undermine system stability when the Bubble burst. When waning confidence in the underlying Credit finally impinged Credit Availability, the system’s inability to sustain rapid Credit growth ushered in the cycle’s downside.
Today, the “Moneyness of Risk Assets” is the critical Bubble and Risk Intermediation issue. To be sure, Fed and global central bank liquidity injections, backstops and assurances have created epic market distortions that dwarf those from the mortgage finance Bubble.
The entire world believes central bankers will support stock, bond and asset prices. Everyone believes central bankers will ensure liquid markets. Most believe global policymakers will forestall financial and economic crisis for years to come. And it is these beliefs that account for record securities prices in the face of a disconcerting world.
There are all kinds of serious issues related to a six-year period of near zero rates, massive liquidity injections and central bank market support (all on a global basis). I would argue that global fixed income has undergone historic risk mispricing – which is especially problematic considering the record $4.0 TN of global corporate debt issued this year. Tens of Trillions of suspect sovereign debt have been grossly mispriced. And especially with an increasingly disinflationary backdrop taking hold throughout the global Real Economy Sphere, there is (unappreciated) parabolic growth in Credit risk way beyond even the late-stage of the mortgage finance Bubble.
To be sure, the gulf between the perceptions of “Moneyness” and mounting global Credit risk grows by the week. It’s worth noting that debt from Argentina, Venezuela, Ukraine, Russia, Brazil and the energy-sector provide a reminder of how abruptly market adjustments can unfold. There are ominous parallels between this year’s faltering Periphery and subprime 2007.
I worry a lot about global Credit risk. I worry more about illiquidity. Financial Sphere inflation, heavy risk intermediation and the “Moneyness of Risk Assets” combine to nurture historic market liquidity risks. To be sure, six years of zero rates (along with repeated market interventions) ensured that Trillions flowed into various funds and products perceived as highly liquid stores of wealth (“money-like”). Wall Street – and especially the ETF complex – has fashioned scores of perceived liquid low-risk products that invest in illiquid underlying instruments (stocks, corporate debt, municipal debt, EM, etc.). “Money” continues to flood into stock index funds and products, with the perception that these types of vehicles are low-risk and highly liquid (courtesy of the Fed).
This serious marketplace liquidity risk problem began to manifest in 2012, then again in the spring of 2013 and once more this past October. Each episode was met quickly by aggressive central bank liquidity measures and assurances. Each market rescue further emboldened risk-taking and leveraging. In the process, the gulf between the perception of “moneyness” and escalating liquidity risk grew only wider.
Right here we can identify a key systemic weak link: Market pricing and bullish perceptions have diverged profoundly both from underlying risk (i.e. Credit, liquidity, market pricing, policymaking, etc.) and diminishing Real Economy prospects. And now, with a full-fledged securities market mania inflating the Financial Sphere, it has become impossible for central banks to narrow the gap between the financial Bubbles and (disinflationary) real economies.
More stimulus measures only feed the Bubble and prolong parabolic (“Terminal Phase”) increases in systemic risk. In short, central bankers these days are trapped in policies that primarily inflate risk. The old reflation game no longer works.
It’s also worth noting that Friday’s jobs data confirm that the Fed has fallen far behind the curve. Benefiting much of the U.S. economy short-term, trouble at the Periphery of the global Bubble has seen financial conditions loosen at the Core (rising securities prices, lower mortgage and corporate borrowing costs, etc.). King dollar is increasingly destabilizing, spurring “hot money” away from the faltering Periphery and to the inflating U.S. Bubble. Bubble excess beckons for Fed tightening, though they will surely be fearful of further elevating king dollar and upsetting highly unstable markets.
There are reasons why central bankers and central banks have a long history of conservatism. Risks are much too great for experimentation – experiments in “money,” loose Credit and aggressive stimulus. History has shown unequivocally that you don’t want to monkey with money and Credit. Central banks monkey with securities and asset markets at all of our peril.
We now see all the world’s major central banks trapped in a monetary experiment run amuck.
Not surprisingly, especially considering the length and results from prolonged monetary stimulus, deep divisions have developed within the central banker ranks. This week saw more public policy criticism from past and present members of the Bank of Japan. There is also this deepening rift between Draghi and the Germans. Draghi continues to talk tough and assure the markets he’s ready for QE, with or without German consent, surely believing they will have no choice but to come around. The Germans believe “monetary financing” is illegal. Draghi counters that it would be “illegal” if the ECB did not pursue its 2% inflation mandate. How this plays out has major ramifications for the global Bubble.
I’ll conclude with more wisdom from Bill Gross: “Markets are reaching the point of low return and diminishing liquidity.” I’ll add that it’s really important to Bubble analysis that the ability for central bankers to inflate bond prices has essentially run its course. Low returns on fixed income and virtually no return on savings foster Bubble-inflating flows to equities. But it also ensures that when this Bubble bursts – a global Bubble, in stocks, bonds and asset prices generally, that has made it to the heart of contemporary “money” – there will be limited scope for Financial Sphere reflationary measures. And it’s when confidence falters in “money,” perceived “money-like” instruments and policymaking more generally, that we will come to see clearly that you can’t cure a debt crisis with more debt.