The Collapsing Periphery
By: Doug Noland
Friday, December 12, 2014
This week saw things take a turn for the worse for the Faltering Periphery Bubble. On the back of crude oil's $8.03 collapse (to five-year lows), Venezuela CDS surged another 1,402 bps to 4,151 bps. Ukrainian bond yields surged 517 bps this week to 28.63%. Russian ruble yields jumped another 95 bps to 12.82%. On the currency front, the Russian ruble was slammed for another 9.25% (down 43.6% y-t-d). The Colombian peso fell 3.7%, the South African rand 2.1%, Indonesia rupiah 1.4%, Chilean peso 1.1% and Indian rupee declined 0.8%. The Chinese renminbi declined a not insignificant 0.6% against the dollar this week.
Importantly, the Periphery's core has fallen under major duress. The Mexican peso was hit for 2.7% (down 11.7%) this week, with the Brazilian real down 2.5% (down 11%) and the Turkish lira 1.7% (down 6.5%). Brazilian CDS surged 48 bps to a one-year high 212 bps. Mexican CDS jumped 22 bps to a one-year high 112 bps. Brazilian stocks sank 7.7%. Turkey CDS rose 36 bps to 185 (high since October). Indonesian rupiah yields jumped 34 bps to 8.11%.
With EM currencies faltering, local currency denominated debt has been under pressure. Yet, for the most part, dollar-denominated EM debt has performed well - that is, until this week.
Importantly, the EM dollar-denominated bond dam gave way. Russia dollar bond yields surged 59 bps to 6.62%. Brazil yields jumped 47 bps to 4.56%. Turkey yields rose 45 bps to 4.45%; Mexico 18 bps to 3.53%; Peru 22 bps to 3.80%; and Colombia 28 bps to 3.94%. Venezuela dollar-denominated yields jumped 381 bps this week to 24.28%.
Interesting dynamics at the Core. German stocks were hit for 4.9%, Spanish stocks fell 6.9% and Italian stocks dropped 7.4%. Greek stocks collapsed 20%. Greece five-year bond yields surged 332 bps to 9.15% - "worst week since the euro crisis." Italian to German bond spreads widened 25 bps, and Portugal to German spreads widened 38 bps. Here at home, the S&P500 fell 3.5%. Yet the Morgan Stanley Retail index gained 0.8%. Healthcare, pharmaceuticals and the airlines advanced. Treasury bond yields sank to below closing levels from tumultuous October 15th. Corporate bond spreads blew out to the widest level since the October market tumult.
U.S. equities bulls are clinging to a sanguine view of collapsing oil and commodities prices. A well-known strategist was on CNBC late Friday afternoon espousing the bullish thesis, comparing the current backdrop to back in 1997 when the U.S. expansion soldiered on, impervious to EM debacles and sinking commodities. Yet EM debt was miniscule then compared to now. Global debt was a fraction of today's level. U.S. debt was about a third the current level. And, importantly, the amount of global leveraged speculation was a small fraction of that which surely inflates speculative markets these days. That said, the Russian collapse and LTCM debacle almost brought the global financial system down in October 1998.
Especially these days, "Core vs Periphery" analysis is as fascinating as it is challenging. As always, it's as much an "art" as it is a "science."
Importantly, initial stress at the Periphery only tends to spur financial flows to the Core.
Serious unfolding issues can go so far as to rejuvenate Core Bubble Dynamics. At some point, however, a profoundly consequential transformation begins to unfold: De-risking/de-leveraging (liquidity "vaporization") actually begins to suck liquidity from even Core markets.
Increasingly powerful contagion momentum at the Periphery is apt to jump what had seemed an impermeable fire wall (between Periphery and Core). This will manifest first, often subtly, at the Core's periphery. Still, with bullishness having become so engrained throughout the Core marketplace, critical warning signals will be readily dismissed.
I believe Collapsing Bubbles at the Periphery have at this point attained irreversible momentum. And the further that crude, commodities and EM currencies fall, the less likely EM countries, corporations and financial institutions will have the wherewithal to service huge amounts of dollar-denominated debt. A critical issue to ponder today is to what extent higher-yielding dollar-denominated debt has been used as fodder for leveraged speculation - for so-called "carry trades" as well as in the proliferation of high-return derivative structures and products. This debt has also found a home in scores of funds that ballooned in size courtesy of central bank measures and an unmatched global yield chase. The amount of dollar-denominated EM debt and its widespread distribution are unprecedented. The associated risks (especially Credit and liquidity) seemed this week to begin resonating.
Back in the late-nineties, the emerging markets were referred to as "roach motels." It's always the case that funds flow so smoothly into EM markets and economies. And as long as flows spur domestic lending, booming securities markets, generally loose financial conditions and economic expansion, the dream can persist that EM policymakers and economic players have learned from previous fiascos. At the same time, I do sympathize with EM. Developed world policy ineptness helped to really, really bury them this time around.
It's a harsh fact of life that "loose money" and attendant Credit and speculative Bubbles provide fertile breeding grounds for fraud and corruption (not even mentioning resource misallocation).
Throw Trillions of cheap finance at "developing" financial and economic systems and you'll at some point be dealing with major problems. And this is fundamental to the "global government finance Bubble" thesis: it's been six years of history's biggest and, by far, most dangerous Bubble. Now that Bubbles are Collapsing and the days of endless "hot money" inflows have turned to a rush for rapidly closing exits, some of the chicanery is coming into clearer view (i.e. Russia, Venezuela, Turkey, Brazil, Mexico, etc.). Just you wait for China.
It is also fundamental to my current analysis that central bank reflationary measures have rapidly lost their capacity to hold the global Bubble together. The wheels almost came off in October. Yet the efforts of Bullard, Draghi and Kuroda turned things around and incited yet another destabilizing speculative run. The market viewed that a Trillion from Draghi and another Trillion from Kuroda would more than offset the end of Federal Reserve liquidity creation. The game would continue.
The game, however, has changed. Flagrant euro and yen devaluation propelled king dollar, in the process giving a powerful bear hug to already deflating Periphery Bubbles. King dollar placed further downside pressure on crude and commodities markets. Collapsing crude and commodities impaired financial and economic stability for scores of countries and companies - too many that had ballooned debt (much dollar-denominated) throughout the previous boom.
Huge amounts of global debt have rather suddenly turned suspect, inciting a self-reinforcing flight out of currencies, debt markets and commodities. And the more flows reverse out of the Periphery and head to the bubbling Core, the more destabilizing the unfolding king dollar dynamic for the global financial "system" and economy.
I'm sticking with my view of the existence of a massive "yen carry trade" (short a devaluing yen to leverage in higher-yielding instruments elsewhere). As was experienced during October's bout of market instability - and as we saw at times again this week - any yen rally almost immediately fosters problematic de-risking/de-leveraging. And the assumption has been that as long as Kuroda remained at the helm, ongoing yen devaluation could be taken to the bank. This is reasonable and it may still play out this way. Indeed, the assumption of ongoing yen devaluation has been key to the resilient Bubble at the Core.
Yet, from the game aspect of it all, trading dynamics have undergone some subtle yet important changes. Nowadays, yen weakness powers king dollar - at the expense of Collapsing Periphery Bubbles. In a world where the Periphery and Core Bubble Dynamics have so profoundly diverged, no longer does yen devaluation keep the global Bubble afloat.
And I think it's reached the point where yen weakness has actually become destabilizing for the overall global Bubble. Yen devaluation works to sustain huge amounts of speculative leverage, but at the same time resulting dollar strength has pushed the unfolding EM collapse to the breaking point. This new dynamic provides a real policy quandary. Throwing more liquidity at the problem isn't going to help.
The Fed released its Q3 2014 Z.1 "flow of funds" report this week. I won't take as deep a dive as usual. From my perspective, what appears on the surface as a relatively benign Credit backdrop is in reality one with extraordinary vulnerability. I look out to 2015 and it is not clear how the system achieves ample Credit growth to sustain elevated securities markets, profit expectations and bullish optimism for the markets and real economy more generally - especially with ominous global storm clouds now gathering on the horizon.
Total Non-Financial Debt (TNFD) expanded at a 4.4% rate during Q3, up from Q2's 3.4% and compared to Q3 2013's 3.5%. Total Household debt expanded at a 2.7% rate, down from Q2's 3.4%. And while Household Mortgage debt posted its first expansion in four quarters (0.7%), non-mortgage Consumer Credit slowed to a 6.4% pace, down from Q2's 8.2% and Q1's 6.6%.
Total Business borrowings expanded at a 5.2% pace, up slightly from Q2's 5.0% - but weaker than Q1's 6.0%. State & Local government borrowing contracted at a 2.8% pace during Q3, more than reversing Q2's 1.2% increase (which was the first positive number in five quarters).
The star for the quarter, federal borrowings, expanded at a 7.2% annual pace, up significantly from Q2's 2.5% rate.
In seasonally-adjusted and annualized rates (SAAR), TNFD expanded $1.801 TN, up from Q3's $1.370 and Q1's $1.688 TN. It was actually the strongest SAAR Credit growth since Q4 2012 ($1.962 TN). It is certainly worth noting that at SAAR $913bn, federal borrowings accounted for about half of TNFD. Household Debt expanded SAAR $366bn (mortgage $67bn and Consumer $206bn). Total Business borrowings expanded SAAR $605bn. State & Local contracted SAAR $84bn.
With equities under a little pressure during the period, Total Household Assets declined slightly in Q3 to $95.410 TN. And with Household Liabilities increasing $121bn (3.5% rate), Household Net Worth declined $141bn during the quarter to $81.349 TN. Over the past year, Household Assets increased $5.467 TN, with Net Worth inflating $5.140 TN. Net Worth was up a staggering $11.823 TN in two years and $26.664 TN in four years. As a percentage of GDP, Household Net Worth has increased from 331% to 463% in four years - to return almost to the record level from the end of 2007 (476%). There would be significant economic impact if Household Net Worth were to give back a few years of inflated gains.
I am fond of analysis combining Treasury Securities, Municipal debt, GSE Securities, Corporate Bonds and Equities as a proxy for Total Marketable Securities (TMS). After beginning 1990 at about $10 TN, TMS ended the nineties at about $33 TN. By the end of 2007, TMS had inflated to $52 TN. As a percentage of GDP, 2007's 371% compared to 1990's 178% and 1999's bubbly 355%.
TMS ended Q3 at $70.79 TN, or 403% of GDP (both down slightly from Q2). TMS is now up $27 TN, or 62%, from the end of 2008. It is also worth noting that Equities at 200% of GDP surpasses 2007 (182%) and is almost back to 1999's record 209%. And despite talk of system "deleveraging," Total Debt Securities to GDP ended Q3 at 203%, up from 2007's 182%, 1999's 147% and 1989's 114%.
One doesn't have to go too crazy in search for cause and effect. The Federal Reserve's Balance Sheet expanded SAAR $291bn during the quarter to a record $4.508 TN. Fed holdings jumped $720bn over the past year, for 19% growth. This puts the two-year open-ended QE operation (announced in the summer of 2012) at a staggering $1.700 TN, for 58.8% growth. It's also worth noting that Security Credit jumped $189bn, or 16%, over the past year, to a record $1.373 TN. Throughout the financial sector, no expansion is even remotely comparable to Federal Reserve and Security Credit.
Home mortgage borrowings expanded SAAR $77bn during Q3. This compares to 2005's $1.128 TN, 2006's $1.080 TN and 2007's $771bn. Amazingly, six-years of ultra-loose monetary policy have done little to spur mortgage Credit expansion. And with Fed Credit growth supposedly ending and corporate Credit increasingly vulnerable to the forces of risk-aversion, mortgage Credit becomes only more critical to overall system Credit expansion. A strong case can be made that lowering market yields (and declining mortgage rates) no longer has much impact on mortgage borrowing (Household mortgage borrowings up 1.3% over the past two years!).
It is worth noting that GSE Securities expanded SAAR $225bn during Q3 (to $7.834 TN), up from Q2's SAAR $185bn expansion. GSE Securities increased $240bn in 2013, the first growth since 2008. And with Fannie and Freddie now moving to lower lending standards, Washington appears ready for another push of GSE-induced Credit growth. As difficult as it is to believe, we'll have to again keep close tabs on the GSE over coming quarters.
But the winner of the Q3 Z.1 Credit Sweepstakes goes to, once again, the U.S. Treasury.
Treasury Securities expanded SAAR $914bn during the quarter to a record $12.756 TN. Over the past year, Treasury Securities increased $799bn, or 6.7%, with a two-year gain of $1.500 TN, or 13.3%. Since the end of 2007, outstanding Treasury Securities has increased $7.656 TN, or 150%. Over this same period, total Household Debt declined about $420bn (to $13.414 TN).
Tough to call this "deleveraging."
Expanding upon comments made earlier, I think "ominous" when I analyze this Z.1. There is very little to indicate that an unprecedented expansion of Federal Reserve and Treasury Credit has resuscitated a private-sector Credit cycle. Corporate debt has expanded briskly over recent years, but even this important source of system Credit is now susceptible to both global and domestic forces.
My analytical hunch is that "hot money" flowing freely into our booming securities markets helps explain the robust asset price inflation backdrop in the face of lackluster underlying Credit dynamics.
Thus far, troubles at the Global Bubble's Periphery have ensured that king dollar flows inundate Core U.S. markets. But, again, there will be a point where Global de-risking/de-leveraging leads to waning risk-taking and liquidity - even at the Core.
I've argued for awhile now that the maladjusted U.S. economic structure requires in the neighborhood of $2.0 TN of annual non-financial Credit growth. The number for Q3 was $1.801 TN. System Credit has remained meaningfully below the $2.0 TN bogey since 2012. Yet I would argue strongly that the Fed's massive QE program short-circuited typical dynamics.
Miraculously, QE provided "money" for inflating securities prices, for ensuring ultra-loose corporate Credit conditions, for federal and state receipts, for corporate cash-flows and earnings, for record stock buybacks, for record M&A and for lots of spending (especially by the wealthy!). QE incited leveraged speculation and booming "hot money" flows. But QE has ended (for now).
I expect the post-QE landscape to be one of disappointing market performance, weakening corporate profits, less financial engineering and waning growth in government revenues (resurgent deficits!). I look out to 2015 and it's not clear how we get anywhere near the $2.0 TN system Credit growth bogey.
"Hot money" is the big wildcard. King dollar flows could help to sustain inflated securities markets, in the process inflating Household Net Worth (perceived wealth) and spending. But with my view that the global Bubble has burst, probabilities for a problematic Risk-Off dynamic impacting the world has increased significantly.
In that scenario, I don't see the sources of sufficient liquidity and system Credit expansion to keep the U.S. Bubble markets and Bubble Economy levitated.
To summarize, six-years of unprecedented fiscal and monetary stimulus has ensured that everyone is today fully dressed up, liquored up, and silly eager for The Big Party. "Where's the punchbowl?" "Where is it, and I mean now!" "Oh crap, where on earth did it go!!" "Who took it away!!" "I'm telling you to bring it back right now or there's going to be some serious trouble!!!" What a fiasco.