Saturday, July 11, 2015
Global markets this week approached the edge – then recoiled, as they tend to do. Over recent years it’s become the typical pattern. Wait long enough and market stress is met with whatever desperate policy response it takes at that moment. Officials in China moved aggressively to adopt their belligerent brand of “whatever it makes” central market control. Crazy stuff. And as market participants expected, the Game of Chicken saw the Greeks and Europeans eventually cave to market pressure. Markets win again. Long live the king.
So has this been just another blip presenting buying opportunities - or something much more serious? To be sure, the situations in China and Greece continue to fascinate. We’re living history real time 24/7.
My view is that China and Greece are both Broken. But that certainly won’t stop the manic markets from their short-term focus and speculative impulses. Rewards have been too reliable for too long. There’s nothing like a bout of hedging and shorting to get market operators salivating at the prospect of an abrupt reversal of hedges and short squeeze. Still, we can’t take our focus off what is unfolding in the intermediate- and longer-term.
No doubt about it: markets will do what the markets will do. The optimists – who have accumulated great financial power over the past six years – are programmed to trust that policymakers have things well under control. The possibility that this is all one historic Bubble that could now blow up at any time is wacko.
On a weekly basis, I attempt to place developments into context. I see the global government finance Bubble as the grand finale of a historic period of serial Bubbles spanning several decades. This is an extraordinarily dangerous period – financially, economically, socially and geopolitically. The Bubble has made it to the heart of the global monetary system, to the very foundation of “money” and Credit: to central bank “money” and government debt. Virtually unlimited demand for this “money” has ensured unprecedented over-issuance. Governments everywhere are desperate to contain monetary disorder that is now escalating out of control.
Massive monetary inflation has inflated precarious securities and asset Bubbles on a global basis. It has spurred unmatched wealth redistribution and inequality. And the more folks come to appreciate the permanence of this “New Normal,” the deeper the acrimony, discontent and geopolitical risk. And the bigger and more vulnerable Bubbles inflate, the greater the impetus for additional monetary inflation and only greater government control. China has built on lessons learned from the West.
I am convinced that the global government finance Bubble has been pierced. This helps explain why Greece and China (as well as Puerto Rico) have erupted simultaneously. In Europe, ECB QE has inflated bond Bubbles including those in Portugal, Spain, Italy and France, only to bypass a desperate Greece. In China, massive fiscal and monetary stimulus worked chiefly to inflate a historic stock market Bubble. In Europe, Asia and the Americas, efforts to sustain financial Bubbles only exacerbate the divergence between inflating securities markets and deteriorating fundamental prospects. At this point, a crisis of confidence in government finance and policymaking is unavoidable.
Meanwhile, markets rejoice at the notion of the Chinese resorting to blatant inflationism. The ECB will surely pick up the pace of QE. The Japanese now have an excuse to extend their reckless QE program that chiefly inflates speculation. At the Fed, a tightening of policies (not a meaningless little 25bps rate bump) is pushed out so far as to be invisible. Many global equities markets remain not far off record levels. So why are commodities so depressed?
It will be an interesting weekend in Athens, Brussels and Europe more generally. The press is alive with articles and analysis detailing the dual capitulation of nemeses Tsipras and Merkel. There may be an agreement this weekend. There will, however, be no resolution to the “Greek” crisis anytime soon.
Greece is Broken. Confidence has been shattered. The banking system is bust. So there will simply be no way to quickly bounce back from capital controls and having the banking system shuttered for a couple weeks. Importantly, the very real possibility of the return of the drachma cannot be erased from memory. “Money” wants out – out of Greek banks, out of Greek investment, out of the Greek economy and out of Greece generally. Devoid of confidence and a functioning banking system, the Greek economy is in a death spiral. It will now take a tremendous amount of new finance to keep Greece afloat. Going forward, the lurking specter of the drachma will severely hamstring recovery.
The IMF appreciates that Greece today needs a huge new assistance program. But they also have rules. Greece has already defaulted to the IMF, so new “money” will not be forthcoming from the International Monetary Fund. The ECB also (supposedly) has rules. And I suspect Mario Draghi would even agree with Bundesbank President Jens Weidmann and others: At this point Greece is hopelessly bust. Sitting on tens of billions of suspect Greece obligations already, the ECB will tread carefully here as well. OK, so who’s the sucker at the table?
I’ve always envisioned there’d come a point when the Germans had been pushed to far. Backlash would inevitably ensue. Festering anger would erupt, in unGerman-like fashion. Thus far, the “mad as hell…” Greek people have spoken. As for Germany, they have been blanketed with vitriol and unfair criticism. Far too ofter they have become the convenient scapegoat. Will German citizens now ensure that their voices be heard?
German politics is entering a period of uncharacteristic uncertainty. It appears that Chancellor Merkel, finance minister Schaeuble and other key officials now believe Grexit is necessary and inevitable. But under what circumstances will they finally bite the bullet? Seemingly the entire world is now pressuring the continuation of a course German leadership views as destined for complete failure.
Of course, the Germans don’t trust that the Greeks will suddenly start living by agreements, especially after the public referendum and with an economy in collapse. They’re appalled at the contempt Greek politicians and citizens have toward their lenders. The Germans also see political risks erupting throughout Europe. To be sure, this euro currency experiment has become a colossal problem.
The Greek people have shouted out their utter disdain for the status quo – a backdrop that today ensures a period of only greater hardship and social upheaval. It’s difficult for me to disagree with what I believe is the current view of German leadership: at this point, additional assistance should be marshaled to assist the transition of Greece outside of the euro.
This primary issue is not so-called “austerity.” It’s wrong and unproductive to scapegoat the Germans. The critical issue is disregarded: by now it’s clear that the dysfunctional Greek economy is not sustainable inside the euro zone. The harsh reality is that as part of the euro monetary regime both the Greek economy and banking system are financial black holes. It’s the wrong currency for that economic structure: throw “money” in and it leaks right out. Who is willing to keep writing these checks? Who can afford to?
Greek dislocation will continue to foster various major risks. Yet the bursting Chinese Bubble foments more dangerous global financial, economic, market and geopolitical risks.
July 8 – Wall Street Journal (Andrew Brown): “Far more than simply a market crisis, the turmoil on the Shanghai Stock Exchange is viewed by China’s leadership as a potential security threat to the regime. That helps explain the barrage of measures unleashed by financial authorities to counter a sudden market downturn that threatened to shake public confidence in the government. In that sense, the unprecedented rescue moves, including a multibillion-dollar fund set up by Chinese brokerages at the government’s behest to buy blue chips, is a preview of what’s to come following the passage last week of a national-security law that massively expands the definition of threats to the state to cover almost every aspect of domestic life, including ‘financial risk,’ as well as international affairs. The law explicitly states that economic security is the foundation of national security.”
July 10 – Financial Times (James Kynge): “On Sunday, the new graduates of Tsinghua University are set to gather in their smartest attire to celebrate degrees from one of China’s most prestigious institutions, a place that has fostered generations of political leaders. Just after the ceremony starts — according to a written agenda — the graduates must ‘follow the instruction and shout loudly the slogan, ‘revive the A shares, benefit the people; revive the A shares, benefit the people’.’ To outsiders, this may seem a curious sentiment with which to send China’s best and brightest forward into their careers. More commonly, the tropes of patriotic education are concerned with issues such as national unity and strength, socialist ideology, the recapturing of China’s past glories and washing away a century of shame inflicted by imperialist Japan and western powers. But the elevation of A shares into this rarefied pantheon of national priorities hints at the centrality of the battle that Beijing has joined to restore calm to its slumping stock markets and, in the process, revive its own credibility. This is because the A-share rout risks something much bigger than lost investments; the Communist party’s basic definition of how power and the people are supposed to interact is also in jeopardy.”
I’ve expected the bursting of the Chinese Bubble to be “frightening.” It’s commenced. I never really contemplated things would quickly turn so bizarre. “Revive the A shares, benefit the people.” Investigating “malicious short selling.” The banning of selling by large holders and company insiders. Forcing institutions to buy. Blaming rumor-mongering and foreign meddling. Media gag orders against negative reporting. Widespread trading halts and illiquidity. And the bear market is barely underway… So much in China is Broken.
“The bloom is off the rose,” as they say. Perhaps Beijing can restore some semblance of domestic confidence in Chinese equities. Tall order. But I fully expect foreigners will be looking to get out. As a foreign shareholder, would I trust Chinese communist officials to protect my rights and financial interests? Going forward, should we expect a focus on the interests of shareholders or the leadership’s political interests and fixation on global power? While the crowd ponders buying the dip, I increasingly question whether China at this point is even “investable”?’’
Some of the reporting is reminiscent of the initial subprime eruption. The general expectation is that stock market losses won’t have a significant impact on consumer spending or the overall Chinese economy. Only a small part of the population will be impacted. The government will protect against broader economic effects.
From my perspective, the key issue is the impact the stock market dislocation will have on the broader Chinese Credit Bubble. While very few appreciated it at the time, subprime amounted to the initial piercing of the mortgage finance Bubble. It represented the catalyst for a mortgage Credit tightening, escalating risk aversion, de-leveraging and a self-reinforcing general tightening of Financial Conditions. There was ebb and flow, repeated policy responses and bouts of wild volatility. Confidence proved resilient longer than I expected, with everyone somehow remaining oblivious to the ramifications of the bursting of a major financial Bubble.
Prior to recent tumult, there were already serious cracks in Chinese Credit. Housing Credit had slowed sharply, while commodities related Credit issues were also likely taking a toll. The government’s reflationary stock market gambit has been instrumental in sustaining rapid system Credit growth – massive ongoing Credit expansion required to keep a highly maladjusted and unbalanced economy levitated. With equities market Credit contracting, I expect a forthcoming huge issuance of government debt in the name of “system stability.”
I’ve seen a couple analysts question what China’s response to its faltering stock market Bubble means in terms of the ascendancy of the renminbi to an international “reserve currency.” This is an extremely important issue, although I’ll come at it from a somewhat different perspective: What do cracks in the Chinese Credit Bubble, the bursting of China’s stock Bubble and their heavy-handed and bizarre responses mean to the general stability of the Chinese currency?
I do not believe one can overstate the vital importance of the stable renminbi link to the U.S. dollar. I have posited that this “peg on steroids” has incentivized an enormous flood of “hot money” into China and, more specifically, into high-yield Chinese debt instruments. It is this massive speculative “carry trade” that has Chinese officials so jittery. It was this “hot money” Bubble that had officials backtracking from their 2014 managed currency devaluation. And it was the combination of faltering apartment and “hot money” Bubbles that was behind policymakers rolling the dice on the reflationary wonders of the stock market (they saw it work in the U.S.!) It could all come crashing down.
The renminbi began the week at 6.2055 to the U.S. dollar, right where it ended 2014. China’s currency ended the week down a meager 0.06% to 6.2094. In spite of all the market tumult and uncertainty, the renminbi peg to the dollar has been solid as a big boulder. So are we to believe that Chinese officials can control the stock market, control their Credit system, control the economy, control the media and “foreign meddling”, control financial flows, control speculation and, as well, control the currency peg to the dollar? I know, I know: they have control over $3.7 TN of international currency reserves. I’ve always believed this reserve position was much more vulnerable to disorderly “hot money” flight than commonly perceived. We may yet find out.
Throughout their historic boom, the Chinese have bent all kind of “rules” – economic, financial and otherwise. Can they continue to flout the fundamental rule that economic, financial and market instability spurs currency volatility and vulnerability?
I have posited that a proliferation of global currency “carry trades” (borrowing/leveraging in devaluing currencies to speculate in higher-yielding instruments in other currencies) is the unappreciated key source of speculative finance helping to fuel the global government finance Bubble. And for the most part, to this point currency markets have remained extraordinarily orderly and predictable. Draghi has orchestrated an orderly devaluation in the euro, essentially granting free “money” for those borrowing/shorting the euro to finance securities purchases elsewhere. Kuroda is going on three years of QE Fest, devaluing the yen and fomenting what I believe is one of history’s great speculative plays (“yen carry trade”). The Chinese have certainly done their part, with their currency peg to the dollar ensuring easy speculative profits to anyone willing to short the dollar, yen or euro and use the proceeds to leverage in high-yielding Chinese Credit instruments and securities.
The euro is vulnerable to Grexit. The crowded euro short has as well shown susceptibility to squeezes. The yen this week again indicated potentially robust demand in the event of a bout of de-risking/de-leveraging. The yen gained a quick 1.5% against the dollar during Wednesday’s nervous trading. At this point, no one is questioning China’s commitment to its currency peg. But they sure have their fingers in a number of leaky dikes.
I question whether currency markets are about to enter a period of acute volatility. Could they crack? It’s been awhile since the last episode of serious currency market tumult. I suspect a tremendous amount of “carry trade” leverage has accumulated since then.