Reminiscing about 2012

Doug Nolan

Credit booms are powerfully reinforcing. New Credit provides additional purchasing power that spurs spending, economic output, corporate earnings/cash-flow and income growth. 
 
Monetary expansions, as well, fuel inflating asset prices, most notably in securities and real estate. In both the Financial Sphere and the Real Economy Sphere, Credit expansion and its myriad inflationary effects beget more self-reinforcing Credit.

Importantly, the upside of a Credit Cycle feeds off the commanding forces of cooperation and integration. The economic pie is expanding, and it becomes easily-recognized that working together offers more than zero-sum outcomes. In prolonged booms, a “virtuous cycle” appears almost a certain, natural outcome.

Yet the inevitable Credit cycle downturn ensures a vicious sequel. The bursting of the Bubble sees so many rewarding boom-time endeavors turn infeasible, unprofitable or unworkable. 
 
Hopes are dashed and dreams are crushed. Confidence, flowing over-abundantly throughout the boom, is suddenly in such short supply; faith wanes in policymaking, the markets, finance and in institutions more generally. Meanwhile, the unfolding bust illuminates the inequities and nonsense from the Bubble-period. Powerful forces then shift to tearing at the fabric of cooperation, integration and good faith that were so crucial throughout the boom period. 
 
Yesterday’s partner is today’s competitor.

Nowhere did this historic global Credit Bubble have greater integrative influence than in Europe. The euphoria of the victory of democracy and free-market Capitalism, along with technological advancement, financial innovation and developments in contemporary monetary management, emboldened Europe’s leaders to take the fateful plunge toward unprecedented integration, including a common currency.

To appreciate the complexities of the current market, economic and geopolitical backdrop, it’s helpful to return back to that fateful summer of 2012. European integration was under existential threat, though the seriousness of the situation was appreciated by few. A potentially momentous crisis of confidence had gathered powerful momentum. Fear of a European periphery debt crisis was being transmitted to a more general questioning of the solvency of the European banking system. And with Europe’s banks major operators in derivatives and throughout EM, European travails had begun reverberating throughout global markets.

Markets were increasingly questioning the viability of the euro currency – and such concerns invariably raised doubts as to the stability of global finance and, accordingly, economic prospects around the globe. As I chronicled the seriousness of developments back in 2012 (in the face of the media and pundits generally downplaying associated risks), my analysis appeared extremist and misguided. It was only later that inside accounts (notably from the Financial Times) confirmed the extent to which European policymakers had worked to avert acute financial and economic crisis.

Bond manager Jeffrey Gundlach made headlines this week with the comments “central banks are losing control.” I would suggest that central bankers actually lost control back in 2012. 
 
Mario Draghi’s “whatever it takes” pledge was part of desperate measures to save the euro. Yet “whatever it takes” actually amounted to concerted central bank intervention to shield global markets and economies from the intensifying forces of the downside of a historic Credit Cycle. 
 
The global Credit boom persevered for a few more years, right along with historic market distortions and economic maladjustment. Downside risks have grown significantly.

European bank stocks (European Stoxx 600) this week traded to the lowest level going back to those dark days of 2012. It’s worth noting that European Banks rallied 90% from summer 2012 lows to July 2015 highs. During this period, Italy’s FTSE Italia All-Share Banks Sector Index surged from 6,000 to a high of 15,557. “Whatever it takes” fueled an almost doubling of Italian and Spanish equities indices. Germany’s DAX index traded at 6,000 in the summer of 2012, then more than doubled to 12,374 by April 2015.

“Whatever it takes” stock gains may have been spectacular, yet they have been overshadowed by the phenomenal collapse in European bond yields. Excerpted from my July 26, 2012 CBB: “Spain's 10-year yields jumped 62 bps to 6.91% (up 187bps y-t-d). Italian 10-yr yields rose 20 bps to 6.01% (down 102bps). Ten-year Portuguese yields rose 8 bps to 10.01% (down 277bps).
 
The new Greek 10-year note yield declined 19 bps to 25.19%.”

“Whatever it takes” became a global phenomenon, both from the standpoint of central banker policy and securities markets inflation. Replicating Draghi, BOJ head Haruhiko Kuroda unleashed shock and awe monetization and currency devaluation. The dollar/yen was trading at 78 in the summer of 2012 before extraordinary BOJ stimulus worked to devalue the yen to 124 to the dollar by mid-2015. After trading below 8,500 in the summer of 2012, Japan’s Nikkei surged to above 20,700 by August 2015. Japan’s TOPIX Bank Stock Index rallied from 100 in the summer of 2012 to 246 by June 2015. And while the S&P500 rose 66% from summer 2012 lows to record highs, it’s worth noting that the U.S. broker/dealers (XBD) surged from 80 to 203.

It’s no coincidence that European and Japanese equities have led the developed world on the downside the past year. There’s no mystery surrounding the poor performance of global financial stocks. Bullion’s almost 2% rise this week boosted 2016 gains to 22%. The yen has gained almost 14% against the dollar so far this year. Ten-year bund yields traded with negative yields for the first time this week. U.S. 10-year Treasury yields traded to the lowest level since 2012.

Despite shoring up reflationary efforts earlier in the year, extraordinary ECB and BOJ monetary stimulus has not been successful. Underlying economic and inflation trends remain problematic in the face of major securities markets inflations. Indeed, the wide divergence between securities market prices and economic prospects ensures acute vulnerability to market risk aversion and risk-off speculative dynamics.

Despite Friday’s 4.1% surge, European banks stocks declined another 1.4% this week (down 25% y-t-d). Friday’s 6.7% rally (reminiscent of U.S. financial stocks in 2008) still left Italian bank stocks down 1.9% for the week - increasing 2016 losses to 44%. In Asian trading, Japan’s TOPIX Banks Stock Price Index sank 5.1% (down 34.3% y-t-d), trading almost back to April lows. Hong Kong’s Hang Seng Financial Index dropped 2.9% (down 15.1%).

Italian sovereign spreads (to bunds) ended the week 13 bps wider to a one-year high 149 bps. Italian spreads have now widened 28 bps in three weeks. Spain’s 10-year bond spread also widened 13 bps this week to a more than one-year high 153 bps. Portugal’s 10-year bond spreads surged 22 bps this week to an 18-week high 327 bps. Greek yields surged 60 bps.  Credit spreads widened significantly throughout Europe this week, sometimes spectacularly.

The murder of a pro-“remain” UK politician further clouds analysis of next Thursday’s referendum. Recent polling had Brexit in a narrow but widening lead. Yet London’s bookies place odds slightly in favor of Remain. Recall that polls had the Scots favoring independence a week prior to their referendum, although the actual vote broke strongly against independence. 
 
The Scottish experience has likely influenced Brexit betting.

Markets have grown comfortable that electorates will bitch and moan but, at the end of the day, will side with the best interest of the financial markets. At some point, I would expect increasingly disillusioned voters to disregard much of the fear mongering. The interests of voters and markets might very well part ways.

The Brexit vote is a serious potential “risk off” catalyst. Significant amounts of currency and risk market hedging have transpired. This portends a period of unstable markets. If Brexits wins, derivative-related exposures could foment illiquidity and market dislocation, as traders are forced to dynamically hedge their derivative books into unsettled markets. Victory for remain would entail the abrupt unwind of hedges across various markets. At least in the very short-run, this would equate to yet another destabilizing short-squeeze.

Still, a vote to remain would do little more than remove a near-term catalyst. European leaders are understandably nervous that a successful Brexit campaign would embolden independent and anti-Europe movements throughout the continent. Yet few believe a remain vote will diminish animosities and hostility toward integration and European leadership.

Back in 2012, Mario Draghi recognized how even the notion that a country might exit the euro could unleash market dynamics that would rather quickly place Europe’s markets and banking system in peril. “Whatever it takes” was orchestrated specifically to expel any market doubt with regard to the viability and sustainability of European monetary integration. On the back of a wall of liquidity and inflating securities markets, Draghi’s gambit held things together for a few years. That said, the ECB bet the ranch – and was compelled to ante up in response to market instability early this year. The outcome of the game is very much in doubt.

While Britain is not even a member of the euro, Brexit provides a test of ECB policymaking. Is Europe robust or fragile? Has relative financial stability been nothing more than a brittle ECB-fabricated façade? Are the forces mounted against integration and cooperation too powerful to disregard? Is European integration – along with the euro currency - viable long-term? It’s an untimely test, with confidence in Europe’s banks already waning. It’s furthermore an untimely test because of faltering confidence in the ECB and contemporary global central banking more generally. Global market instability has again resurfaced and there will be no resolution next week.

June 17 – Financial Times (Sam Fleming): “Close watchers of the Federal Reserve were bemused this week after an unidentified policymaker forecast just a single increase in official interest rates over the coming years. On Friday James Bullard, the president of the St Louis Federal Reserve, revealed that he was the rate-setter behind that unexpectedly low dot on the Fed’s ‘dot plot’ of rate forecasts, as he executes a big shift in his views of the economy that puts him at odds with other rate-setters who see a gradual series of increases. The former hawk said in a statement that he expects rates will remain unchanged in 2017 and 2018 following a single rate rise, in a leap towards an ultra-dovish outlook.”


The FOMC has confounded Fed watchers with its abrupt pivot back to ultra-dovishness. There shouldn’t be much confusion. Global market fragility has reemerged, and the Fed’s rapid retreat has confirmed the seriousness of what’s unfolding. Central banks have thrown everything at the problem, yet markets remain as vulnerable as ever. At least the world was not facing the downside of China’s historic Credit Bubble back in 2012.

The Fed has never admitted that global concerns have been dictating U.S. monetary policy since 2012. It has now become clear, throwing the analysis of policymaking into disarray. The harsh reality is also increasingly apparent: global monetary management is dysfunctional and central bankers have become perplexed - without a backup plan. Such an uncertain backdrop is pro-currency market instability and pro-de-risking/deleveraging.

In a replay of 2012, U.S. markets have remained resilient in the face of rapidly escalating European and global risks. Back then our markets ended up being positioned well for “whatever it takes.” They’re again well positioned, it just that whatever it takes it's proving not to be enough.

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