Draghi's Do Whatever it Takes Beats Estimates
January 23, 2015
Let’s return to where we left off in late-December: “Bubble On, Bubble Off.” The thesis remains that the “global government finance Bubble” was pierced in 2014. However, in a world of unprecedented liquidity excess, deflating Bubbles at the “Periphery” further inflate Bubbles at the “Core.” Last year saw faltering Bubbles in the Emerging Markets (EM) and commodities usher in a new King Dollar reign. While the Fed wound down QE, extraordinary measures by the likes of Draghi and Kuroda safeguard the historic boom in global leveraged speculation.
Hot money flooded into U.S. securities markets. These trends run unabated in early-2015.
I’m also not backing away from the view that a prolonged experiment in global monetary inflation is “failing spectacularly”. The stakes are just incredibly high – financial, economic, social, geopolitical… Global policymakers refuse to admit their failings. They will not accept the obvious: printing “money” – creating perceived wealth through electronic debit and Credit entries – will not rectify the world’s ills. Indeed, runaway financial Bubbles lie at the heart of an extraordinary array of worsening global maladies. Disastrously, key central banks have coalesced into the stand that monetary measures have not been aggressive enough.
Especially here in the US, the notion of central bank policy failure is lampooned. My view emanates from “Financial Sphere vs. Real Economy Sphere” analytical framework. Central bank “money” creation further inflates already overinflated financial systems around the globe. This only exacerbates the dangerous divergence between inflating financial Bubbles and disinflationary forces that are overwhelming real economies. If anything, the problems associated with wealth redistribution and inequality – on a national as well as global basis – have become only more conspicuous as some Bubbles burst and others continue to inflate. The geopolitical environment is again noteworthy, albeit Ukraine, Russia, Yemen, the entire Middle East, Paris or Greece.
It is a myth that central banks control a general price level. It's mere folly that monetary policy spurs real and sustainable wealth creation. Doubling down on monetary inflation primarily exacerbates global market and Credit Bubbles. There is increasing risk of a crisis of confidence in the markets, in policymaking and in finance more generally.
This week saw German bund yields close at 36 bps. More incredibly, French sovereign yields ended the week at 54 bps – after averaging about 3.0% in the period 2009-2013. French yields averaged 7.0% during the nineties. Italian yields ended the week at 1.52% - after trading above 7% in 2012 and compared to the nineties average above 8.0%. Spain 10-year yields closed the week at 1.37% - after trading above 7.5% in 2012 (nineties avg. above 8%). Portuguese yields dropped to 2.44% - down from the 2012 high of 15.22%. European equities also celebrated “whatever it takes” Draghi. The French CAC 40 has posted y-t-d gains of 8.6%, with German stocks up 8.6%, Italian equities 7.9%, Portugal 9.6%, Finland 9.7% and Spain 2.9%.
A Friday Bloomberg headline: “Global Bond Markets Jump as ECB Buying Spurs Scarcity Demand.” Globalized “money printing” has inflated bond prices to historic extremes. One could certainly argue that ECB rate, bailout and QE policies have inflated a historic Bubble in European financial asset prices. I found the Q&A segment of Draghi’s press conference (after announcing the ECB’s plan for open-ended $60bn monthly QE) intriguing to say the least.
Question: “What do you answer to those arguing that a possible effect of the QE will be to rise some price bubbles on certain categories of assets?”
Draghi: “…We monitor closely any potential instance of risk to financial stability. So we’re very alert to that risk. So far we don't see bubbles. There may be some local episodes of certain specific markets where prices are going up fast. But to have a bubble… one should also identify the… dramatic increase in leverage or in bank credit. And we don’t see that now. However, as I said, we are alert and if bubbles are of a local nature, they should be addressed by local instruments, namely macroprudential instruments rather than by monetary policy.”
As Draghi’s policy course now mimics that of the Federal Reserve, so do his comments. Actually, his reference to “local episodes” recalls chairman Greenspan’s spurious claim that real estate was a “local market” – hence not prone to nationwide Bubbles. I countered at the time that Bubble Dynamics were prevalent throughout mortgage finance – and that the highly distorted Bubble market was very much a national (international) and policy-induced phenomenon. And Draghi’s assertion that the lack of a “dramatic increase in leverage or in bank credit” is inconsistent with Bubbles – and that “macroprudential” be used to counter localized excess – comes directly from the Fed’s playbook. So, what about central bank Credit?
What about global “carry trade,” securities and derivative-based leverage? And why would “macroprudential” be viewed as a credible tool to counter securities market Bubbles when central bank policy is specifically designed to boost securities prices?
Question: “…What would you say to those who are concerned that ECB buying up bonds - electronically printing money - whatever one calls it, is the first chapter in a story that leads inevitably towards hyperinflation? What’s your response to that?”
Draghi: “…I think the best way to answer this is, have we seen lots of inflation since the QE program started? Have we seen that? And now it's quite a few years (since) we started. You know, our experience since we have these press conferences goes back to a little more than three years. In these three years we've lowered interest rates, I don't know how many times, four or five, six times maybe. And each time someone was saying, ‘this is going to be terribly expansionary. There will be inflation.’ Some people voted against lowering interest rates way back at the end of November 2013. We did OMT. We did the LTROs. We did TLTROs. And somehow this runaway inflation hasn't come yet. So what I'm saying is that certainly the jury is still out. But (there) must be a statute of limitations also for the people who say there will be inflation. Yes, when please? Tell me within what?”
For almost six years now, I have argued that the key issue is policy-induced market distortions and attendant financial Bubbles (as opposed to consumer price inflation). The history of monetary inflations is that once commenced they become almost impossible to end. This era’s policy experiment with manipulating securities market inflation makes certain that policy exits will be even more unbearable. Most regrettably, it’s reached a point where a global securities bear market will have devastating consequences – on markets, on economies and geopolitics. So central banks keep pumping and distorting markets – and market operators continue playing the game.
I believe we’ve now reached a precarious phase of instability where confidence in this global monetary experiment is waning. After all, there are years of experience to examine, along with rather conspicuous global financial and economic fragilities. Few have faith that “money” printing will rectify Europe’s - or the world’s - deep structural maladjustments. At the same time, there remains overwhelming confidence that acute fragilities ensure desperate policymakers continue to backstop the markets with liquidity abundance. Things do get crazy at the end of cycles – with lots of “money” slushing around to entice a wildly speculative marketplace. Increasingly, however, it is apparent that central banks have lost control of the massive pool of global speculative finance that they spawned and nurtured.
I believe history will look back to last October’s global, multi-asset class “flash crash” as a warning gone unheeded. Similarly, last week’s shock by the Swiss National Bank’s (SNB) to break the franc’s peg to the euro will also be seen as a harbinger of global market turmoil.
The post-SNB market shock was full of fascinating commentary. “A loss of trust.” One popular pundit called it “the worst central bank policy mistake in 40 years.” Most simply couldn’t fathom Swiss central bankers abruptly changing policy without providing the markets ample warning and time to adjust. This completely shattered the understanding that has developed over the years between market participants and their cherished central bankers.
Well, for much too long central banks have been making promises and assurances they will inevitably be incapable of fulfilling. SNB currency operations required the accumulation of several hundred billion of securities – with major ongoing euro devaluation ensuring huge portfolio losses. The Swiss instituted the extraordinary peg to the euro to stem capital inflows, believing back in 2011 that the crisis of confidence in euroland was of a short-term nature. But with Draghi about to move forward with shock and awe “money” printing, the peg was untenable. This currency link had created such enormous distortions that to ensure marketplace liquidity would surely have required a minimum of hundreds of billions of additional SNB purchases - and massive portfolio losses.
At this point, the sustainability of globalized market-based finance rests upon central bank assurances of “liquid and continuous markets.” It is this promise that underpins highly leveraged securities speculation that now encompasses the globe. It is the guarantee of liquidity and continuous market pricing that provides the foundation of global derivatives markets, especially hedging markets that rely on dynamic trading strategies (adjusting positions dynamically in response to changing market prices).
When the SNB ended the peg on January 15th, the swissy immediately surged 40% against the euro. A huge market dislocated in illiquidity. Those on the wrong side of currency derivative trades had no opportunity to hedge. Those leveraged (short) in swissy “carry trades” were instantly blown out. This wasn’t supposed to happen. This broke a cardinal rule between central banks and the markets.
At the heart of my premise is the analytical view that central bank market assurances sow the seeds of their own destruction. Promise markets stability, liquidity and price continuity and the resulting leverage, hedging and speculative flows will ensure an ugly day of reckoning – market illiquidity and dislocation. This is especially the case in today’s backdrop of a massive and growing pool of speculative finance. First of all, central bank policies are leading to only greater market excess and price distortions. Secondly, all the “money” printing inflates the scope of this “Crowded Trade” of speculative finance now hopelessly destabilizing global markets and economies.
Importantly, currency markets are in disarray. The Swiss franc dislocation provided an overdue reminder of how quickly highly leveraged trades can blow apart. It’s worth noting that this week’s losses in the New Zealand dollar (4.4%) and Australian dollar (3.8%) surpassed the decline in the euro (3.1%). New Zealand and Australian dollars have been popular “carry trades” targets. Eastern European currencies were under further pressure this week. The Singapore dollar, Malaysian ringgit and Turkish lira all declined at least 1% this week. King Dollar also inflicted more pain in commodities markets. WTI crude dropped 7.8% to an almost six-year low. The GSCI Commodities Index sank 3.0% this week (down 9.2% y-t-d) to the lows since early-2009 lows. All is not well in the global economy.
I would be remiss for not mentioning China. I actually believe unfolding Chinese Credit issues likely help to explain the absolutely dismal commodities performance, while perhaps also explaining the unrelenting bid to the dollar and Treasuries. China now faces the same dynamic that has plagued much of the world: liquidity injected to ameliorate Credit stress and spur economic activity instead stokes a speculative Bubble in the stock market. Chinese markets have exacerbated the global divergence between securities market Bubbles and deteriorating fundamental prospects.
For the most part, it was a big week for global equities – especially in Europe and the emerging markets. Market volatility is extraordinary, indicative of festering market structural issues.
Short squeezes and the unwind of hedges can at any time spur market rallies. Yet there are further indications of insipient risk aversion and de-leveraging. Draghi’s do “whatever it takes” this week helped emboldened the bullish crowd. And QE does help accommodate the ongoing deleveraging in commodities and currency markets. QE also stokes “developed” sovereign debt market Bubbles. But I don’t see this endless “money” printing as confidence inspiring when it comes to global economic prospects. All this dollar-denominated EM debt remains a major issue. In the face of the ongoing QE onslaught, Credit conditions are tightening – in U.S. high yield, in China, in commodity-related corporates globally and EM generally.