HORRIBLE RISK VERSUS REWARD / CREDIT BUBBLE BULLETIN

Horrible Risk Versus Reward

Doug Nolan

Friday, April 17, 2015

I found myself this week reflecting back to this past May, shortly after Ben Bernanke began his (reportedly) $250,000 dinner meetings.

May 6 - Bloomberg: “David Einhorn, manager of the $10 billion Greenlight Capital Inc., said he found a recent dinner conversation with former Federal Reserve Chairman Ben S. Bernanke scary. ‘I got to ask him all these questions that had been on my mind for a long time,’ Einhorn said in an interview today with Erik Schatzker and Stephanie Ruhle on Bloomberg Television…‘It was sort of frightening because the answers were not better than I thought they would be.’”

Bernanke’s new blog attempts to answer some of his critics. So far the “answers” have not been “better than I thought they’d be.” Not to be hypercritical, but even after all these years and dramatic experiences, Dr. Bernanke demonstrates an unsophisticated understanding of markets. And as international markets have assumed an ever more powerful command over global economies – and policymakers over the financial markets - is it coincidence that monetary policy has become largely dictated by academics? I find it somewhat ironic that Bernanke signed up this week as senior advisor to one of the world’s most successful hedge fund groups.

April 16 – New York Times (Andrew Ross Sorkin and Alexandra Stevenson): “For eight years, Ben S. Bernanke, the former Federal Reserve chairman, was steward of the world’s largest economy. Now he has signed on to advise one of Wall Street’s biggest hedge funds. Mr. Bernanke will become a senior adviser to Citadel, the $25 billion hedge fund… He will offer his analysis of global economic and financial issues to Citadel’s investment committees. He will also meet with Citadel’s investors around the globe. It is the latest and most prominent move by a Washington insider through the revolving door into the financial industry… Mr. Bernanke joins a long parade of colleagues and peers to Wall Street and investment firms… In an interview, Mr. Bernanke said he was sensitive to the public’s anxieties about the ‘revolving door’ between Wall Street and Washington and chose to go to Citadel, in part, because it ‘is not regulated by the Federal Reserve and I won’t be doing lobbying of any sort.’ He added that he had been recruited by banks but declined their offers. ‘I wanted to avoid the appearance of a conflict of interest,’ he said. ‘I ruled out any firm that was regulated by the Federal Reserve.’”

I’m reminded of Willie Sutton’s response to why he robbed banks: “Because that’s where the money is.” I could only chuckle at the New York Magazine headline: “Helicopter Ben Makes it Rain – for Himself.” It’s absolutely laughable that the former Fed chair suggests part of his decision for hooking up with a hedge fund was his sensitivity to public anxieties about the “revolving door” between Wall Street and Washington.

I, at least, would rather see Bernanke working with a traditional regulated financial firm, although his compensation would surely be much less. 

Especially in this Bubble backdrop with the global leveraged speculating community playing such an integral role, it just doesn’t look good. In an era where public confidence in the Federal Reserve is so thin and vulnerable, why couldn’t Bernanke have just stuck with his post-Fed career of writing, teaching and a few lucrative dinner engagements? After all these years, I still miss Chairman Volcker.

In his April 7th post, “Should Monetary Policy Take Into Account Risks to Financial Stability?”, Bernanke further builds his case as to why the Fed should not rely on monetary policy to counter asset inflation and Bubbles. He leaves slightly ajar the possibility of at some point resorting to monetary tightening, although that requires the “weighing of benefits and costs.” Bernanke references recent studies where – no surprise here – the associated costs of tightening monetary policy greatly outweigh the benefits.

“Although, in principle, the authors' framework could justify giving a substantial role to monetary policy in fostering financial stability, they generally find that, when costs and benefits are fully taken into account, there is little case for doing so. In their baseline analysis, they find that incorporating financial stability concerns might justify the Fed holding the short-term interest rate 3 basis points higher than it otherwise would be, a tiny amount…”

A few basis points? Surely every sophisticated hedge fund manager in the world would scoff at such research. Directly from Bernanke: “Again, the bottom line is that large increases in the short-term rate based on financial stability considerations alone would involve costs that well exceed the benefits.”

Legendary hedge fund manager Stan Druckenmiller was out this week sharing some of his wisdom (including an insightful WSJ op-ed). He argued (on Bloomberg Television) that current ultra-loose monetary policy provides a “Horrible Risk Versus Reward.” Obviously he’s spot on. Two major U.S. bursting episodes in the past 15 years provide overwhelming proof of the profound financial, economic, social and geopolitical costs associated with Bubbles. If that’s not sufficient, the last two decades witnessed scores of devastating Boom and Bust Cycles around the globe.

While the “blunt tool” of global monetary policy has by now bludgeoned everyone senseless, the world’s numbness to risk did begin tingling a bit late in the week. As the current poster child for the devastating costs associated with major Bubbles, Greece is back in the forefront.

In reality, the “Greek” disaster has been absolutely great for markets. The summer of 2012 crisis of confidence in Greece, European periphery bonds, the region’s banks and the euro unleashed open-ended QE at the Fed, BOJ, SNB and elsewhere. More recently, ongoing Greek and European fragility made certain that the ECB joined the global QE soiree. And the more Greece has appeared to be sliding closer to the brink, the deeper European bond yields have sunk into the great unknown (pulling down Treasury and global bond yields in the process). Here at home, global fragilities empowered the dovish Fed to do nothing (not even a little 25bps baby-step) that might risk rocking the apple cart. This ensured Treasury yields completely defied U.S. fundamentals, especially with king dollar enticing enormous Bubble flows into American stocks, corporate debt and the real economy.

Bernanke concluded his most recent post (“Why Are Interest Rates So Low, Part 4: Term Premiums,” April 13, 2015) with the sentence, “Thus, the recent decline in longer-term yields and term premiums in the US remains something of a puzzle.” Bernanke again invokes the “global savings glut” thesis as the likely explanation for Alan Greenspan’s 2006 “conundrum” (long-term yields remaining low in the face of Fed “tightening”). I argued in 2006 that low bond and MBS yields indicated dangerously distorted Bubble markets. The bond market appreciated escalating Bubble risk – and correctly discerned forthcoming extraordinary policy measures. In the process, tremendous systemic damage was wrought in that 2006-2008 period of (“Terminal Phase” Bubble) market dysfunction.

Some nine years later, there should be little confusion surrounding low (“Conundrum 2.0”) bond yields. Global central banks have demonstrated there is no limit to either the amount of “money” they are willing to create or quantities of securities they will buy. They have essentially guaranteed uninterrupted abundant and cheap market liquidity. Policymakers have assured market participants that financial crisis (or even a recession!) will not be tolerated. Worse yet, central bankers have repeatedly demonstrated no appetite for even a small ration of global de-risking/de-leveraging. In total, myriad interventions have had momentous impact on global market risk and “term premiums.”

Nowadays, the larger global Bubbles inflate the higher the probability of additional QE. This market perception pushes yields lower and stocks higher – in the process fueling a precarious self-reinforcing Bubble Dynamic. Central bankers should never so vigorously manipulate market risk perceptions – especially in an extraordinarily speculative marketplace. The end result has been the most highly distorted Bubble markets in financial history. At this point, everyone has been forced on board (some kicking and screaming).

Greek five-year bond yields surged 325 bps this week to 18.31%, the high since those dark days of 2012. Increasingly pricing in default, Greek CDS surged 770 bps this week to 2,775 bps. Notably, especially late in the week, thus far dormant contagion effects began to awaken. Portuguese bond yield spreads to German bunds surged 48 bps. Italian spreads widened 19 bps and Spain spreads widened 30 bps. Portuguese CDS jumped 21 bps, Italy 22 bps and Spain 19 bps. An index of European (subordinated) bank debt jumped 27 bps to a 2014 high. And after having rallied significantly on the back of Draghi’s QE, European corporate junk bonds this week suffered a sharp reversal of fortunes. Meanwhile, Thursday and Friday trading saw Germany’s DAX equities index suffer a two-day decline of 4.4%.

Blackrock’s Larry Fink has been out front warning of latent market illiquidity risks. Discussing liquidity Friday with UBS’s Axel Weber (on Fox Business), Fink admonished global regulators for failing to address this issue. Yet with the world awash in central bank liquidity and market participants having grown convinced of its endless supply, why on earth would anyone fret illiquidity? The chief worry has instead been the risk of being underinvested and not fully capturing rallies.

April 16 – Financial Times (Ralph Atkins): “‘I was flabbergasted, I could not believe it.’ The veteran portfolio manager at a top US fund was this week recalling the US Treasury ‘flash crash’ exactly six months ago, when yields in the world’s largest government debt market swung wildly in a matter of minutes. Statistically, such events happened only once every 3bn years, Jamie Dimon, chief executive of JPMorgan Chase, noted recently… But maybe it would help if such events were frequent? As Mr Dimon observed in a letter to shareholders this month, ‘almost no one was significantly hurt’ by what happened on October 15. Instead the ‘flash crash’ triggered a welcome debate about the underlying fragility of the post-2007 crisis global financial system. As Mr Dimon pointed out, it served as a ‘warning shot across the bow’ of investors and market participants.” 
 
The S&P500 rallied 16% off of October 15th “flash crash” lows. The Semiconductors rose as much as 34% and the Biotechs 50%. In reality, so-called “flash crash” “warning shots” have fallen on deaf ears, working instead to embolden what is now a powerful late-cycle buy the dip mentality. Indeed, the too hasty policymaker responses to previous bursts of risk aversion (2010, 2011, summer 2012, spring 2013, October 2014 and early-2015) solidified the market view that officials have adopted the role of eager promoter and defender of global risk markets.

Bubbles burst. Yet Bubbles can thrive on loose monetary conditions for so long that seemingly nothing can get in their way. And the bigger the Bubble the greater the risk of a destabilizing shift in market perceptions. The longer “risk on” gains momentum and becomes more deeply entrenched, the higher the probability of a “black swan.”

From my vantage point, excesses have reached the point where a bout of “Risk Off” de-risking/de-leveraging risks another “flash crash” and liquidity panic. 

As I’ve argued in the past, so-called “black swans” are actually not the as-advertised “low-probability events”. Indeed, the deepening perception of low probability bad market outcomes over time creates a high probability for market dislocation catching The Crowd unprepared. The next “flash crash” is as close as the trend-following, performance-chasing and “high-frequency” trading Crowds moving concurrently to take some risk off the table. The proliferation of derivative strategies and trading provides enormous additional market leverage to the upside as well as the downside.

Greek default and possible “Grexit” create potential major “Risk Off” catalysts. 

That monetary policy has so numbed global market risk senses significantly raises the stakes. Policy-induced runaway global equities Bubbles have unfolded in the face of diminishing economic prospects. This elevates the risk of “Risk Off” escalating into something quite problematic. And that Chinese officials moved Friday evening to tighten the finance fueling their runaway stock market Bubble adds another important source of global uncertainty.

It’s worth noting that the crowded dollar bull trade was under pressure this week. The dollar index fell 1.8%. The crowded euro short was pressured by a 1.9% rally in the euro currency. The “yen carry trade” was pressured by a better than 1% yen rally versus the dollar. The crowded commodities short was also under pressure. Crude surged 7.9%, with natural gas up 4.9%. As Treasuries rallied, corporate Credit and MBS spreads widened.  Risk Off has an opening.

April 17 – Reuters (Marc Jones and John O’Donnell: “The European Central Bank has analyzed a scenario in which Greece runs out of money and starts paying civil servants with IOUs, creating a virtual second currency within the euro bloc, people with knowledge of the exercise told Reuters.

 

Greece is close to having to repay the International Monetary Fund about 1 billion euros in May and officials at the ECB are growing concerned. Although the Greek government has repeatedly said that it wants to honor its debts, officials at the ECB are considering the possibility that it may not, in work undertaken by the so-called adverse scenarios group. Any default by Greece would force the ECB to act and possibly restrict Greek banks' crucial access to emergency liquidity funding. Officials fear however that such action could push cash-strapped Athens into paying civil servants in IOUs in order to avoid using up scarce euros. ‘The fact is we are not seeing any progress... So we have to look at these scenarios,’ said one person with knowledge of the matter.”