Majority Mad as Hell

Doug Nolan


“In this unique exploration of the role of risk in our society, Peter Bernstein argues that the notion of bringing risk under control is one of the central ideas that distinguishes modern times from the distant past. Against the Gods chronicles the remarkable intellectual adventure that liberated humanity from oracles and soothsayers by means of the powerful tools of risk management that are available to us today.”

I found myself this week thinking deeply about the now classic (1998) “Against the Gods: The Remarkable Story of Risk.” The notion that new sophisticated approaches to risk management had diminished overall system risk was integral to the 1990’s U.S. boom period. Repeated policymaker resuscitation ensured that over time this already phenomenal Bubble morphed into a global Bubble of epic proportions. And right up until the Lehman Brothers collapse the consensus view held that policymakers had things well under control. Recall that the VIX sank just weeks prior to the so-called “worst financial crisis since the Great Depression.”

It’s no coincidence that near systemic financial collapse was preceded by near manic devotion to the wonders of contemporary risk management. Today, I see parallels between the Lehman failure and the UK people’s decision to leave the European Union. Until the Lehman collapse, the strong consensus view held firm that policymakers would not tolerate financial crisis or severe economic downturn. By late in the cycle, this momentous market misperception had been embedded in prices for Trillions of securities, certainly including MBS, ABS and GSE debt. Importantly, as excesses turned increasingly outrageous (i.e. 2006’s $1TN of subprime CDOs) unwavering faith in the power of policy measures ensured ongoing rapid Credit expansion.

Moreover, unabated Credit growth (and attendant economic expansion and asset inflation) coupled with confidence in policymaker control ensured that inexpensive market risk “insurance” remained readily available. Going back to my initial CBBs, I took exception to the powerful interplay of securities-based finance, “activist” monetary management and booming derivatives and market risk “insurance.” The Fed’s interest-rate and liquidity backstops underpinned securities-based finance, ensuring resilient markets and economies. This safeguarded the supply of cheap market risk “insurance” – protection that was fundamental to ongoing risk-taking throughout the markets and real economy.

An increasingly systemic Bubble was built on an unsound foundation of misperceptions, including confidence that policy measures were readily available to ameliorate financial and economic instability. Panic ensued when the Lehman collapse illuminated the reality that there were powerful forces operating outside of policymaker command and control.

At the time, I believed that the 2008 crisis marked a momentous inflection point for “contemporary finance.” Serious flaws and misperceptions having been fully exposed, I expected a fundamental re-pricing of risk throughout the markets. I thought the days of cheap risk “insurance” were over. Going forward, if market participants desired to reduce risk they would have to liquidate holdings. And considering all the associated havoc, I expected the Federal Reserve and other regulators to adopt an aggressive oversight approach to derivatives generally.

The Bernanke Fed instead pulled out all stops to resuscitate “contemporary finance.” Zero rates and Trillions of QE were adopted with the specific objective of spurring financial market inflation. Indeed, rising securities market prices became the centerpiece of extraordinary measures to reflate the U.S. (and global) economy. Over time it became a case of “whatever it takes” to overcome bouts of market instability and sustain an increasingly unwieldy global Bubble.

Risk premiums and pricing for market “insurance” collapsed. Instead of lingering fear from the near-catastrophic 2008/2009 experience, greed reemerged more emboldened then ever. Clearly, it was assumed, policymakers learned from 2008 and would not tolerate another crisis. Especially after 2012, “Whatever it takes” on a global basis ensured policymakers had the capacity to control developments like never before. “Risk on” finale.

Markets were obviously over-confident going to Thursday’s UK referendum. It’s all understandable. As booming securities markets over the years turned increasingly powerful and dominating, markets held sway over central bankers, politicians and electorates alike.

Who’s been willing to mess with bull markets and economic recovery? Of course, the average Brit was disgusted with so many aspects of European integration. But once in the voting booth they certainly wouldn’t risk a faltering currency, sinking stock market and attendant economic uncertainty. That would be nuts. Markets – including risk insurance – were priced as if it was largely business as usual: markets dictating government policies, while central bank measures dictate the markets. Yet for voters it was anything but business as usual. For the Majority, Mad as Hell…

(Inflationist) Theory held that central banks could effortlessly print “money” that would inflate both the markets and the general price level. Such a reflation would help grow out of previous debt problems, while spurring wealth creation and renewed prosperity. Yet predictable consequences include latent financial fragilities, economic maladjustment and destabilizing wealth redistributions and disparities. Responding to obvious shortcomings, central bankers were compelled to only ratchet up monetary inflation. The past few years of “whatever it takes” have been reckless, and it’s coming home to roost. It’s increasingly apparent that popular discontent has reached critical mass, and critical development are not under central bank control.

Sure, central bankers are as committed as ever to crisis management. Global liquidity swap lines will be wide open. There will market interventions and ongoing liquidity backstops. More QE is on the horizon. But the process has turned dysfunctional and the consequences of aggressive monetary inflation extraordinarily unpredictable. Economies have fragmented.

Markets have fragmented. Societies have fragmented. Political unions are fragmenting. It’s that old dilemma that central bankers can create liquidity but it’s difficult – these days impossible? - to dictate where the “money” flows in such a fragmented world.

It’s a popular argument that banks are healthier (better capitalized) these days than back in 2008. As I’ve chronicled for awhile now, global stock prices support the view that banks today confront extraordinary risks. I would add that I believe global securities market vulnerabilities greatly exceed those of 2008. A hedge fund industry and ETF complex that have each swelled to $3.0 TN are on the list of market risks that have inflated significantly since 2008. From a more real economy perspective, risks unfolding in Europe, China, Asia and EM, more generally, greatly exceed those from 2008. Actually, one has to be a real optimist to see a bright future for European, Asian or EM banking systems.

Brexit comes at a terrible time for European banks and Europe’s securities markets more generally. To be sure, Friday trading put an exclamation mark on what was already bear market trading action. European bank stocks were down 14.5% Friday, increasing y-t-d losses to a nauseating 29%. UK banks were under intense selling pressure. Royal Bank of Scotland sank 27% in Friday’s chaotic session, while Barclays and Lloyds fell 20% and 23%. Elsewhere, Credit Suisse sank 16% during the session, with Deutsche Bank down 17% (down 35% y-t-d). Friday trading also saw Banco Santander fall 20%.

UK stocks opened Friday down about 8% but closed the session with losses of 3.2%. Spanish stocks sank 12.4% in wild trading, increasing y-t-d losses to 18.4%. Stocks in France sank 8.0%, pushing 2016 losses to 11.4%. Friday trading saw equities sink 5.7% in the Netherlands, 6.4% in Belgium%, 7.0% in Portugal, 13.4% in Greece and 7.0% in Austria.

Recalling the tumultuous 2011/12 period, Italy is again becoming a market concern. Ominously, Italian bank stocks sank 22.1% Friday, a crash that pushed 2016 declines to 52%. Friday trading saw the Italian stock market (MIB) sink 14.5%, increasing y-t-d declines to 34%. And with Italian 10-year bond yields up seven bps to a four-month high 1.62%, the spread to bund yields surged 14 bps this week to a two-year high 167 bps.

European periphery spreads widened significantly Friday. Spanish 10-year bond spreads (to bunds) widened 30 bps Friday to a one-year high, with Italian spreads 29 bps wider. Portuguese spreads widened 39 bps and Greek spreads surged 91 bps.

Panic buying saw 10-year U.S. Treasury yields drop 19 bps Friday to 1.56%, the “largest single-day drop in 5½ years.” UK yields sank 29 bps to a record low 1.08%. German yields dropped another 14 bps Friday to a record low negative 0.05%. Swiss bond yields fell 13 bps to a record low negative 0.56%. After trading almost $100 higher overnight, bullion finished Friday’s session up $59 (4.7%).

In Asia, the Japanese equities bear market gathered further momentum. With Friday losses of almost 8.0%, Japan’s Nikkei 225 sank another 4.2% this week to an eight-month low (increasing y-t-d losses to 21.4%). Japanese banks (TOPIX) were clobbered 8.0% during Friday’s session, boosting 2016 losses to 37%. The Shanghai Composite’s 1.1% decline increased y-t-d losses to 19.4%.

US stocks this week again outperformed most developed markets. The S&P500’s 3.6% Friday drop put the week’s decline at 1.6%. Not so bullishly, Friday trading saw the banks (BKX) drop 7.3% (down 13.1%) and the broker/dealers (XBD) sink 7.9% (down 16%).

Currency trading has turned wildly unstable. Friday trading saw the Swedish krona drop 3.7% versus the dollar. Norway and Demark saw their currencies lose more than 2%, though these were modest declines compared to some key Eastern European EM currencies. Poland’s zloty sank 4.3% Friday, the Hungarian forint fell 3.5% and Czech koruna declined 2.4%. Friday trading saw the South African rand sink 4.6%. The Russian ruble fell 2.3% and the Turkish lira dropped 2.6%. Unsettled Friday action saw the Mexican peso trade to a record low, before ending the session down 3.8%. What’s unfolding south of the border?

Yet the real action was with the British pound and Japanese yen. The pound traded overnight at 1.324 to the dollar, a 30-year low – before cutting Friday’s losses to 8.1% at 136.79. And with the yen surging an alarmingly quick 5% versus the dollar, the pound was at one point down about 15% versus the yen.

Currency markets badly dislocated. And discontinuous markets are a major problem for those dynamically hedging derivative exposures as well as players that are leveraged. The pound’s abrupt fall was understandable considering the amount of hedging going into the referendum. But in the yen’s discontinuity I discern important confirmation of the thesis that there remains enormous amounts of leverage in short yen “carry trades” (short/borrow in yen to finance trades in higher-yielding currencies).

The impairment of the leveraged speculating community remains an important facet of the bursting Bubble thesis. There are surely casualties from Thursday night and Friday’s trading fiasco. And as hedge fund losses mount, the potential for major redemptions appears increasingly likely. We should expect de-risking/de-leveraging to intensify. And while central banks will continue to abundantly supply a liquidity backstop, I don’t believe such measures at this point will tame problematic volatility. Market correlations have run amuck. Hedging strategies are problematic. So risk exposures have to get smaller. Uncertainties have become too great.

June 24 – UK Daily Express (Jonathan Owen): “Five European countries may seek to follow Britain’s lead in leaving the EU in a Brexit domino effect, Germany has warned… Tensions are rising across the EU, with Denmark, France, Italy, the Netherlands, and Sweden all facing demands for referendums over Europe. In a statement, German Chancellor Angela Merkel said: ‘There is no point beating about the bush: today is a watershed for Europe, it is a watershed for the European unification process.’”

European integration is again under existential threat. And while disintegration will likely unfold over the coming years, a crisis of confidence in the markets could erupt at any point.

Confidence in Europe’s banks is faltering badly. I believe faith in the ECB’s capacity to hold the banks and securities markets together is waning. How much leverage has accumulated throughout European periphery bond markets? And it is a harsh reality of Europe’s financial structure that de-risking/de-leveraging dynamics tend to see rising yields/widening spreads intensify market fears of bank impairment. Then bank worries further negatively impact sentiment in the markets and business community in a problematic vicious spiral.

The ECB could boost QE, but it recently did that. It could buy corporate debt, but it has started doing this already as well. Negative rates only worsen the banks’ predicament. And bankers facing such extraordinary uncertainties will extend Credit cautiously - in Europe, throughout EM and in securities finance. When the world worries about Europe’s financial structure and economic prospects, fears can quickly spread globally. I find myself worrying more about China. U.S. markets have remained resilient. On the one hand, our markets win by default. On the other, best I can tell there is no market in the world that remains so oblivious to a bevy of unfolding financial, market, economic and geopolitical risks. Central banks are losing control and I fear “contemporary finance” is again in the crosshairs.

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