Thesis Update

Doug Nolan

With global risk markets staging a significant rally, it’s an appropriate time to update my bursting global Bubble thesis. Three weeks ago I titled a CBB “Crisis Management.” My view was that mounting global market instability had reached the point where concerted policy measures would be employed in an effort to bolster faltering global Bubbles. I do not expect stimulus measures to succeed in resuscitating the global Bubble that inflated out of the 2009 crisis response. At the same time, policymakers obviously still retain some power to incite rallies in a grossly speculative marketplace.

Let’s try to put things into context. We’ve witnessed history’s greatest financial Bubble. The Bubble has been fueled by a confluence of extraordinary financial innovation (i.e. securitized finance, leveraged speculation, derivatives, state-directed finance, etc.), unmatched debt growth, unprecedented central bank Credit expansion and market manipulation and the global adoption of all of the above. Especially since 2009, global central bankers have adopted extreme monetization and rate measures specifically to target rapid Credit expansion and securities market inflation.

The upshot has been the greatest expansion of speculative finance ever – finance operating as one massive “risk on” global speculative dynamic. When market participants were embracing risk-taking, this massive pool of global finance easily inflated securities and market prices virtually across the board. Over time, the divergence between inflating securities market Bubbles and deflating global economic widened to precarious extremes. Simplistically, the prospect of faltering Chinese and EM Bubbles proved a catalyst for a problematic collapse in energy and commodities prices. Rather quickly, the global Bubble began to deflate as prospects for literally Trillions of rotten Credit began to unfold – commodities-related, China, EM and risky corporate debt more generally. Confidence that policy measures could hold things together began to wane, and market vulnerabilities rather quickly reemerged.

I believe that confidence in global finance and faith in government policy measures have been irreparably damaged. This is central to my thesis that the global Bubble has burst. At the same time, now catastrophic risks ensure that policymakers employ all means to bolster the markets (sustain Bubbles). The outcome, as we’ve witnessed over recent months, is acute global market instability and volatility. When the massive pool of global finance turns risk averse, selling and hedging quickly overwhelm the market into illiquidity and “flash crash” susceptibility. Then, when policy measures are employed to buttress frail markets, the subsequent unwind of substantial short positions and hedges spurs abrupt “rip your face off” market rallies. In short, epic market speculation is one massive Crowded Trade built on a flimsy foundation of faith in experimental policymaking, prone to the type of volatility and uncertainties that create a management and performance nightmare.

Reuters ran an article Monday: “The European Central Bank is checking liquidity levels at a number of Italian banks, including Banca Carige and Monte dei Paschi di Siena , on a daily basis…”

It was a crucial week from my “Crisis Management” perspective. I have referred to Mario Draghi as the world most influential central banker. Recall how Draghi’s failure to deliver additional QE back in early December proved a catalyst for a bout of global “risk off.” Over recent months, Europe once again demonstrated its still festering financial and economic fragilities. And with global markets having recently rallied in anticipation of concerted stimulus measures, there was a lot riding on the outcome of this past Thursday’s ECB meeting.

“Whatever it takes” Draghi was clearly determined wrest back his reputation for “beating market expectations.” He lowered rates further into negative territory. More importantly, the ECB significantly boosted the size of monthly QE purchases by a third to euro 80 billion ($90bn). Moreover, the ECB will commence corporate debt purchases (details to come). Some analysts now expect the ECB to purchase up to $15 billion of corporate debt on a monthly basis. The ECB – and central banks more generally – are desperate to convey they’ve not run short of ammunition.

It’s difficult to believe what has transpired at the ECB under Mario Draghi. Negative interest rates. Trillion annual QE as far as the eye can see – massive monetization of extremely overvalued sovereign bonds (including Greek, Italian and Portuguese) and now overpriced corporate debt. Expectations are that equities could be next. I always expected the Germans to eventually draw the line. Instead, we find overwhelming support for the tenet that once monetary inflation is commenced it becomes virtually impossible to rein it in.

I have argued for some time now that China has completely lost control of its Credit Bubble. 
 
This week provided important additional confirmation.

March 6 – Wall Street Journal (Mark Magnier and Lingling Wei): “China’s leaders made clear they are emphasizing growth over restructuring this year, but suggested they are trying to avoid inflating debt or asset bubbles as they send massive amounts of money coursing through the economy… And for the first time, the Chinese government specified total social financing—a broad measure of credit that includes both bank loans and nonbank lending—as a metric for helping determine monetary policy… Both measures have increased sharply in recent months… This year, the two targets are paired, with both set to rise 13%.”
It’s surprising that China’s move to target 13% broad Credit growth (“total social financing”) didn’t garner more attention. Not only would this see Credit expansion likely more than double the rate of GDP growth, it would could amount to upwards of an astounding $3 Trillion of system Credit expansion.

Using the U.S. Bubble as an example, total (non-financial and financial) Credit growth averaged about $750bn during the nineties. Credit Bubble dynamics had seen debt growth surge to $1.651 TN by 2003, and then inflate to $2.131 TN in 2004, $2.235 TN in 2005, $2.378 TN in 2006 and then the (still) all-time record $2.470 TN in 2007. China’s Credit target is akin to U.S. officials having in 2007 moved aggressively to boost the rate of growth. The problem is that 2007 debt was already of extraordinarily poor quality – enormous amounts of weak mortgage Credit financing over-priced real estate, along with unprecedented amounts of non-productive corporate and household debt (financing a highly imbalanced “Bubble Economy”). 
 
Tremendous system impairment (real economy and financial) is wrought during “Terminal Phase” Bubble excess.

Chinese officials claimed to have studied and learned from the wretched Japanese Bubble experience. And for several years China made varied and repeated efforts to rein in excess. I argued repeatedly that their Bubble would be impervious to timid measures. And as the Bubble attained only more powerful momentum, officials were unwilling to take the significant risks associated with orchestrating a bursting. China has now completely capitulated. It’s now growth at any cost. Let there be no doubt, the costs are potentially catastrophic.

I have referred to a multi-decade experiment with unfettered global “money” and Credit. The U.S. experiment in economic structure, securitized finance and monetary inflation/manipulation went global. And there is the ongoing experiment in European monetary integration. There is as well the EM experiment in market-based finance and international financial flows. And now China is trapped in its own runaway experiment in central management of massive Credit expansion, economic development and currency control.

The Goldman Sachs Commodities Index rallied 10% in two-weeks. Crude (WTI) surged 17%. 
 
The Brazilian real gained about 10% over two weeks, with the Australian dollar rising 6%. 
 
There’s clearly been a major short squeeze unfold throughout commodities and EM. But on a fundamental basis, if Chinese officials ensure upwards of $3 TN 2016 system Credit growth this should at least somewhat help underpin demand for commodities (got gold?).

The Chinese are playing a very dangerous game. Peg (highly suspect) Credit growth at about $3 TN, peg (highly imbalanced) economic expansion at about 6.5% and peg their (now highly suspect) currency versus the dollar. This amounts to truly epic financial and economic impairment. And, importantly, this predicament has become rather conspicuous. Waning confidence in policymaking is fundamental to my bursting global Bubble thesis.

Markets can pretend for a time that Chinese officials have taken measures that have stabilized their finance, economy and currency – and in the process have stabilized global markets. Yet the Chinese and global backdrops are anything but stable. There are already indications that acute monetary disorder is stoking a speculative melee in Chinese debt and some real estate markets.

It’s been my view that Chinese risks have been the major factor weighing on commodities and EM. And while Chinese policies have supported markets in the near-term, risks of a global crisis of confidence now rise (exponentially?) right along with prolonged historic Chinese “Terminal Phase” excess.

It’s worth noting that the euro surged abruptly on the ECB announcement, confounding central banker and market participant alike. Similar to the yen’s recent market-surprising response to additional BOJ stimulus measures, central bankers appear to have lost their capacity to manipulate currency markets. This implies major market uncertainty and volatility. 
 
Another crucial aspect of my bursting global Bubble thesis is that uncertainties now ensure much less leverage throughout various currency “carry trades.” Especially since the summer of 2012, I believe currency speculation-related leverage came to play a prominent role in securities market liquidity around the globe. While the consequences of the recent momentous market shift are masked during squeezes and rallies, I expect the issue of waning liquidity to resurface whenever the next “risk off” unfolds.

It’s worth noting that Italian bank stocks rallied 8% Friday, with European bank stocks up almost 5%. Italian stocks rallied 3.9% this week, with Spanish equities up 3.2%. Italian 10-year spreads to German bunds narrowed 17 bps this week. Portuguese spreads narrowed 19 bps. Greek yields sank 79 bps. 
 
Clearly, some large bets had been waged over recent weeks on the return of systemic crisis in Europe. And perhaps Draghi and the Chinese can hold crisis at bay. But the bottom line is that central bankers have had to resort to only more obvious desperate measures, while the Chinese have succumbed to lunacy. It’s all anything but confidence inspiring.

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