A Tale of Two Entangled Super Bubbles

By: Doug Noland

Friday, April 10, 2015


"This past month may be remembered as the moment the United States lost its role as the underwriter of the global economic system.

True, there have been any number of periods of frustration for the United States before and multiple times when U.S. behavior was hardly multilateralist, such as the 1971 Nixon shock ending the convertibility of the dollar into gold.

But I can think of no event since Bretton Woods comparable to the combination of China's effort to establish a major new institution and the failure of the United States to persuade dozens of its traditional allies, starting with Britain, to stay out. This failure of strategy and tactics was a long time coming, and it should lead to a comprehensive review of the U.S. approach to global economics. With China's economic size rivaling that of the United States and emerging markets accounting for at least half of world output, the global economic architecture needs substantial adjustment. Political pressures from all sides in the United States have rendered the architecture increasingly dysfunctional." Lawrence Summers, April 5, 2015, Washington Post

While on the subject of Larry Summers, it's worth noting that the International Monetary Fund this week seemed to throw its weight behind Summers' "secular stagnation" thesis ("new reality of lower speed limits"). And while the prognosis resonates, I have serious issues with the root cause diagnosis. After all, prolonged Credit Bubbles and attendant resource misallocation, mal-investment, maladjustment and wealth redistribution ensure fragility and debilitated economic systems. Bubbles as well strike a heavy toll on social and political stability. The upshot is mounting stress and divisiveness between social classes, political parties, nations and global economic and security blocks. Accordingly, it is absolutely essential to ward off Bubbles prior to them becoming powerfully ingrained. This is the great lesson global policymakers doggedly refuse to learn.

From an analytical perspective, it's crucial to appreciate that today's "global government finance Bubble" - the "Granddaddy of all Bubbles" - arose from a backdrop of fragility and maladjustment.

Literally decades of financial mismanagement and resulting serial Boom and Bust Cycles set the stage for what would have previously been viewed as unimaginable policy measures. Nowadays, stagnation in real economies ensures that central banking printing inflates financial market Bubbles.

There are pertinent Credit Bubble Tenets at play: "The more systemic a Bubble becomes the less conspicuous its inflationary effects." "Bubbles inflate perceived wealth while destroying real economic wealth." "Credit Bubbles redistribute wealth within economies, with the middle class the inevitable biggest loser." "Global Credit Bubbles redistribute wealth between nations, with geopolitical instability inescapable." "Timid policymaking hamstrung by progressive financial fragility and economic vulnerability is fundamental to 'Terminal Phase' Credit Bubble excess."

Observing the financial world these days, it is difficult not to invoke Mises' "crackup boom."

Europe's Euro Stoxx index jumped 3.1% this week to a new record high, increasing y-t-d gains to 21.3%. The German DAX jumped another 3.6% this week (up 26.2%). Ten-year German bund yields closed at a record low 15 bps. France's CAC 40 Index gained 3.3% (up 22.7%), as French 10-year yields ended the week at a miserly - and new low - 43 bps. The UK's FTSE 250 index surged 3.8% (8.0%). This week saw equities surge 3.7% in Switzerland, 5.8% in Norway, 3.6% in Denmark, 3.4% in Finland, 3.5% in Belgium, 3.0% in Netherlands, 5.2% in Portugal, 3.4% in Ireland, 2.9% in Austria and 2.4% in Italy.

The Bubble in Asian securities, especially China-related, is almost on par with Europe. Chinese stocks surged 5.5% this week, increasing 2015 gains to 24.7%. Incredibly, the Hang Seng equities index surged 9.5% over the past five sessions, as the mainland's equities speculative Bubble now engulfs Hong Kong. Hong Kong's Hang Seng has gained 14% the past month to the highest level since 2007. The Shanghai Composite has inflated an incredible 90% since this past July.

Chinese officials devoted significant resources to the study of the Japanese Bubble experience. They seemed to comprehend key dynamics, having stated in the past their determination not to repeat similar mistakes. I believe China's policymakers had finally decided to bite the bullet and pierce their Bubble. The decision was made to significantly rein in Credit and speculative excess. It's also my view that the Chinese in 2014 embarked on what they hoped would be an orderly (competitive) devaluation against the U.S. dollar.

This policy course, however, was thwarted by the emergence of acute financial and economic fragilities - at home and abroad. The degree of structural impairment had been unappreciated. Risks associated with popping the Bubble had grown too high. Moreover, policy priorities were reworked in response to a shifting geopolitical landscape.

The greater EM Bubble has played prominently - and Europe (i.e. ECB) and Japan (i.e. BOJ, savers and financial institutions) have assumed increasingly powerful roles. Yet for sometime I've viewed the "global government finance Bubble" primarily in terms of "A Tale of Two Entangled Super Bubbles." Without the U.S. so mismanaging the world's reserve currency and flooding the globe with dollar balances, the Chinese Credit system would have never enjoyed such free rein. The Chinese manufacturing base - not to mention apartment developers and buyers - would not have lavished in unlimited cheap finance. And after the collapse of the mortgage finance Bubble, U.S. reflationary measures would not have gained traction without the corresponding historic expansion of Chinese "money" and Credit.

Major Credit Bubbles make for strange bedfellows. The U.S. and China are intense global rivals, increasingly competing for global financial, economic and military power and influence. Yet over the protracted Bubble period these two adversarial powers have grown increasingly dependent upon the other's inflating Bubble - respective Bubbles whose excesses mirror those of their rival. Economies have become deeply integrated, financial systems extremely intertwined and their currencies tightly bound together. The façade of stability holds only so long as these increasingly antagonistic adversaries see it in their individual self-interests to feed the runaway global Credit Bubble.

In the simplest terms: The U.S. is a descending global power with a major Credit Bubble problem; China is an ascending global power with a major Credit Bubble problem. More complexly, precarious Bubble codependency masks latent geopolitical explosiveness.

The U.S. has run more than two decades of unending Current Account Deficits, offsetting the gutting of its manufacturing base with finance, services and Trillions of IOUs. The U.S. resorted to a historic inflation of mortgage Credit to reflate after the bursting of the nineties Bubble. The post-mortgage finance Bubble backdrop has witnessed offensive use of the government's electronic printing press.

This increasingly reckless use of finance has led to a highly dysfunctional global Bubble backdrop, destructive wealth redistribution, heightened fragilities and deep acrimony and antagonism.

The Chinese succumbed to a foolhardy expansion of manufacturing capacity, housing and system Credit. China's Bubble completely got away from authorities after the extraordinary 2009 fiscal and monetary stimulus measures. Plans to rein in excess were then relegated to the backseat. The global backdrop had turned increasingly complex. The "global reflation trade" was collapsing. Commodities and EM - both complexes on the receiving end of enormous Chinese lending and investment - were in serious trouble. This was unfolding just as the Chinese apartment Bubble was finally succumbing.

Time for another CBB Tenet: "There's never a convenient time to rein in major Bubbles."

Importantly, the bursting EM/China apartment/commodities Bubbles coupled with Federal Reserve policymaking incited a destabilizing king dollar dynamic. This dynamic only exacerbated fragility throughout EM, commodities and energy complexes. Meanwhile, China found its currency tied to a rapidly appreciating dollar, much to the detriment of its manufacturers burdened by massive overcapacity and its financial institutions challenged by a rapidly deteriorating Credit backdrop domestically and internationally.

Chinese policymakers confronted an extraordinarily complex backdrop - and very difficult decisions. I imagine they looked at king dollar, surging securities markets and a recovering U.S. economy in somewhat disbelief. And they surely viewed U.S. reflation in terms of America as a re-energized geopolitical rival. The increasingly hard-line and nationalistic Chinese leadership determined it was no time to rein in its Bubble and risk deflating its global power play.

The Chinese (and Russians) were working surreptitiously yet methodically toward developing a counter to (perceived waning) U.S. global dominance. I believe the Ukrainian revolution and Crimea takeover provided a game-changer. Suddenly, the U.S. was spearheading an effort to take a hard-line with Putin and Russia. In response, Putin adopted a belligerent approach, determined not to allow U.S.-dictated sanctions and economic power to alter Russia's policy course. Russia saw the collapse of crude and the ruble as part and parcel of a U.S. plot to undermine Putin and Russia more generally.

It was not long before Putin was off to Beijing to consult with President Xi Jinping.

Surreptitious campaigns for global power and influence were suddenly in the wide open. Putin had to be thwarted - but there was certainly no appetite for military confrontation. The U.S. would impose its financial muscle - power in no small part dependent upon the Fed's Bubble-induced securities market juggernaut. Russia could not be allowed to mess with the U.S. bull market and economic recovery. It became an inopportune time to contemplate a move to normalize U.S. monetary policy.

Not unlike Chinese officials, an increasingly complex global financial, economic and geopolitical backdrop had the Yellen Federal Reserve content to downplay Bubble risks.

April 9 - RT: "The creation of the BRICS reserve currencies pool worth $100 billion will allow member states to depend less on negative processes in the world economy and bypass market volatility, said Russian Prime Minister Dmitry Medvedev. 'Along with the launch of the New Development Bank, it is one of the most important initiatives for countries entering into this association. The agreement establishing a pool of reserve currencies was signed last summer,' said Medvedev... 'Russia is providing $18 billion. Each of the BRICS members may apply to any party to the treaty for loan," Medvedev said, adding that key decisions will be taken by the Governing Council, which consists of either finance ministers or central bank governors. Russia will be represented by the head of the Central Bank of Russia Elvira Nabiullina. 'I hope it [the agreement on establishing the pool - Ed.] will not only strengthen our economic

April 6 - Bloomberg (Sabrina Valle): "A group of Petroleo Brasileiro SA suppliers is negotiating about $3.5 billion in loans from Chinese institutions as China expands support for Brazil's oil industry, the Brazil-China Chamber of Commerce & Industry said. About half of the more than 20 suppliers banned from participating in new tenders with Petrobras amid a graft probe are in talks with lenders including China Development Bank Corp., Export-Import Bank of China and China Export & Credit Insurance Corp., Charles Tang, who heads the chamber, said... The talks follow China Development Bank's loan to Petrobras for the same amount announced April 1. The state-run producer's shares jumped 4.9% that day as the deal eased concern of a looming cash crunch as delays in reporting financial results keep the company out of bond markets."

Major Bubbles coalesce around adaption, evolution, accommodation and, in the end, the embracement of instruments, strategies and policies that would have earlier seemed objectionable.

Who would have thought the Chinese would be willing to accumulate $4.0 TN of international reserves (electronic IOU's from a bunch of over-indebted borrowers)? Well, the Chinese and EM more generally learned from previous crisis experience that large reserve holdings would ward off currency runs and bolster systemic stability.

So International Reserves inflated from $6.6 TN in early-2009 to last year's high of $12.0 TN. This dynamic was fundamental to the "global government finance Bubble" thesis. China and EM central banks (chiefly) accumulated U.S. IOUs, accommodating egregious U.S. reflationary measures. In the process, this accumulation of Reserves required the expansion of domestic "money" and Credit (throughout China and EM economies). Moreover, the growing trove of reserves emboldened the perception that EM economies and Credit systems were now immune to "hot money" exodus, currency runs and burst Bubbles. I have argued that these massive Reserves were instead indicative of unprecedented "hot money" flows, leverage, currency mismatches and inherent fragilities.

Importantly, the accumulation of International Reserves has reversed. From an August 2014 high of $12.033 TN, reserves have dropped $400 to $11.632 TN. As the poster child for how quickly Reserves can go from seemingly abundant to alarmingly depleted, Russia has seen Reserves drop from a 2014-high of $475bn to $309bn.

If Russia had the financial resources, surely Putin would love to play spoiler and tempt Greece's Tsipras into his (anti-US, anti-Europe) sphere of influence. China these days has the financial wherewithal. Chinese investment (see above) in Petrobras and its suppliers played a major role in reversing Petrobras' bonds and CDS, Brazilian bank bonds/CDS, Brazilian sovereign yields, the Brazilian real and EM markets more generally.

From a March high of 487 bps, Banco do Brasil CDS closed this week at 374 bps. Brazil sovereign CDS fell from 312 to Friday's 249 bps. Brazil 10-year real yields have declined from 13.5% to 12.58%. Brazilian equities have rallied 13% off of March 13th trading lows.

April 9 - Bloomberg: "Bull markets are always tough on short sellers. This one in China right now, though, is proving downright brutal. Bearish wagers on the Shanghai Stock Exchange have climbed more than threefold in the past nine months and reached a record 7.46 billion yuan ($1.2bn) on Thursday, a period in which the benchmark equity index jumped 94%. Across the border in Hong Kong, where the Hang Seng Composite Index has surged 7.6% in just the past two days, the gauge's 20 most-shorted stocks surged 18% on average."

Late-stage speculative runs are often fueled by short squeezes. As deteriorating fundamentals and underlying vulnerability begin to manifest, short positions and bearish derivative bets are initiated as both directional speculations and market hedges. At the same time, prolonged bullish cycles ensure upside momentum and general "bullish" inertia. Blow-off tops can be the result of a confluence of policy measures to ward off collapse and an expansive pool of speculative finance that has profited greatly from gaming policy.

There's understandable skepticism that Chinese authorities can hold their increasingly unwieldy Bubble together. Add a stock market Bubble to their already lengthy list of problems. Still, reserves of $3.8 TN are a lot of "money." But how much is needed to sustain the aged Chinese Bubble, it's U.S. counterpart and, perhaps more pertinent at the moment, a faltering global EM and commodities Bubble. In the midst of all the bullish hoopla, it's worth noting king dollar caught a strong bid this week. One of these days, the Super Currency Peg binding the two Super adversaries and their Super Bubbles will need to be disentangled.

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