Bubble Battles

Doug Nolan


July 29 – Wall Street Journal (Anjani Trivedi): “The Bank of Japan is retreating into some much-needed introspection. And while it prepares to do this, it threw markets a not very meaty bone to chew on. The central bank on Friday underwhelmed overexcited expectations for yet another big bang of monetary stimulus. The Bank of Japan announced a paltry 3 trillion yen ($28.5 billion) increase to its purchases of exchange-traded funds to 6 trillion yen in a bid to boost asset prices. It also doubled down on a relatively minor U.S. dollar lending facility to give Japanese companies a nudge to buy assets overseas. Markets seem to have taken the disappointment in stride…”


Currency markets broke stride awkwardly. The yen responded immediately to the BOJ and ended Friday’s session up 3.05% at session highs. The Japanese currency has rather briskly recovered much of its recent pullback.

A sampling of major headlines: “Bank of Japan Takes Modest Easing Action”; “Timid Bank of Japan Move Raises Alarm for Other Economies”; “Bank of Japan Plays for Time with Weak Stimulus”; “Is Bank of Japan Signaling That It’s Running Out of Ammo?”. Disappointing BOJ action elicited comments such as “limp measures”, “dipped into a bag of small tricks” and a “cautious step.”

The markets – and apparently the financial media – beckon not for limp and cautious, but rather for unyielding and radical. If monetary stimulus is not working as prescribed, that obviously means it must be executed more frenetically. If the most aggressive monetary stimulus ever is increasingly ineffective, the only solution is to go completely radical, nuclear and helicopter. Of course it’s reckless and doesn’t make good sense. So markets are especially sensitive to any indication that central bankers might be losing their nerve or contemplating a reassessment.

BOJ governor Haruhiko Kuroda: “I don’t believe we’re approaching the limits of negative interest rates or qualitative and quantitate easing. We’ve been pursuing an aggressive monetary policy for three years, and it’s a natural time for a review.”
Coming two days after Prime Minister Shinzo Abe revealed a gigantic $265 billion stimulus package, in what has become serial “special” stimulus, the Bank of Japan’s announcement took on greater significance. The BOJ might move aggressively in September, but Friday’s disappointment is a timely reminder that there is underlying unease in Japanese policymaking circles.

Prolonged massive stimulus has helped push Japan’s jobless rate down to a modern day record low 3.1%. At the same time, the primary objective of forcing consumer price inflation up to 2% remains elusive. With aggregate consumer prices down 0.4% over the past year, the Bank of Japan Friday slashed their CPI forecast for the current fiscal year to 0.1% from 0.4%. Global downward pricing pressures – including sinking crude prices – suggest little relief is in the offing. At this point, BOJ monetization is like pounding one’s head against a wall.

Japan has been fighting deflationary headwinds since the bursting of their Bubble more than 25 years ago. It was a major Bubble exacerbated by a loosening of monetary conditions in the U.S. back in the late-eighties coupled with intense pressure from the U.S. to stimulate Japan’s economy to help rectify ballooning U.S. trade deficits. And it’s somewhat ironic that in 2016 Japan’s biggest adversary in its post-Bubble deflation fight is engaged in its own Bubble Battle across the East China Sea.

One could argue that Japan lost all control of its Bubble with the onset of post-1987 crash aggressive monetary accommodation. Chinese control was lost with the massive post-2008 stimulus, and it’s been awhile since I’ve read reference to Chinese officials having learned from the Japanese experience. Indeed, seeds for today’s runaway global finance Bubble were planted in Japan and came to full bloom with China’s historic Credit expansion. And for 25 years, global central bankers have chanted “deflation” as enemy number one. But it’s been Bubbles all along. They remain the dominant risk today, as they’ve been all the way back to the late-eighties.

The global government finance Bubble can at this point be simplified into six powerful intertwined forces: 1) Near zero rates and record low bond yields virtually across the globe contributing to generally loose fiscal spending and ever rising country indebtedness; 2) Near $1.0 TN annual market liquidity injections from the ECB; 3) Near $1.0 TN annual market liquidity injections from the BOJ; 4) Annual Chinese Credit growth of about $3.0 TN, powered by state-directed bank lending; 5) Ongoing ultra-dovish Federal Reserve policy – with attendant loose financial conditions and booming perceived wealth in U.S. asset markets (exacerbated by strong foreign sourced flows); 6) The deeply engrained perception throughout global markets that central bankers in concert are committed to doing “whatever it takes” to ensure that markets remain liquid and levitated, a backdrop the promotes risk-taking and leveraged speculation (in the face of mounting risks).

Going back to the earliest CBBs, it’s been a central argument that the transformation to securitized Credit was both a momentous and precarious development. History is unequivocal: Credit is inherently unstable. The thesis that contemporary market-based Credit is highly unstable should not at this point be contentious. And the greater the expansion of contemporary market-based finance, with cumulative latent vulnerabilities, the more overpowering the impetus for governments and central bankers to monkey with and backstop unsound markets. And now decades of backstops, bailouts and reflations have nurtured dysfunctional markets that have regressed to total dependency to ongoing government market manipulation, monetization and reckless monetary inflation.

And this helps explain diametrically opposed global markets views: The bullish perspective sees an unusually stable backdrop (VIX closed the week below 12!), with notably resilient markets having repeatedly persevered through brief bouts of market tumult and various geopolitical developments. Monetary management is “enlightened.” The bearish view sees an acutely vulnerable global financial “system” at this point patched together with “whatever it takes” liquidity injections and market manipulation the likes of which the world has never previously experienced. Policymakers are perpetrating history’s most destructive monetary inflation.

The hope has always been that aggressive global fiscal and monetary stimulus would raise inflationary expectations and spur more generalized Credit and economic booms. It had worked previously, although nothing from the past was comparable to the scope of the mortgage finance Bubble and the subsequent post-Bubble global reflationary free-for-all. The combined inflation of national debt and central bank Credit was so enormous that there would be no turning back from resulting epic Bubbles.

Levitated securities markets and maladjusted economic structures around the world would be sustained by nothing less than perpetual ultra-loose finance, the type that only governments and central banks were capable of providing. Private Credit would be insufficient in scope and too unstable. Securities markets without government support would be too volatile and susceptible to crashes. Perhaps they were unaware that there could be no retreat, but governments did take full control. And the more unstable the financial and economic underpinnings, the more egregious the government interventions required to impose transitory stability. Markets reacted positively to this extraordinary imposition, ensuring overbearing Bubbles with only deeper addiction to loose finance. Desperate policymakers accommodated with regrettable pronouncements of “whatever it takes.”

Bubbles always require rapid and increasing Credit expansion. The global government finance Bubble is no different. The world is generally at near zero rates, negative sovereign yields, large deficit spending and about $2.0 TN of annual global QE. Effects have dissipated, ensuring what was originally “shock and awe” overwhelming force is near the brink of not being enough. Crude has sunk back to near $40. Growth has slowed again in Europe, the U.S. and throughout Asia. With the French economy flat-lining, Eurozone Q2 GDP (0.3%) was half of Q1’s. Considering that some sectors and locations are in powerful Bubbles, 1.5% (annualized) Q2 GDP growth speaks poorly for the overall U.S. economy. Ten-year Treasury yields dropped 10 bps this week to 1.45%, clearly betting against Federal Reserve tightening.

Global markets beckon for more loosening. Markets demand that the Bank of Japan turns crazy reckless, even as evidence mounts that now routine reckless hasn’t worked. The markets need Chinese policymakers to ensure $3.0 TN of annual Credit growth, even though it’s apparent to communist leadership that such a course is fraught with major risks. The markets stipulate that the Draghi ECB must continue printing at a Trillion annualized pace, in the face of unprecedented market distortions, internal policy discord and great financial, economic, social and geopolitical risks.

July 26 – Bloomberg: “China’s stock market calm has been shattered. Shares plunged Wednesday, with a gauge of smaller companies sinking 5.5%, as people familiar with the matter said the China Banking Regulatory Commission is discussing stricter curbs on wealth-management products. A measure of the Shanghai Composite Index’s short-term volatility doubled, after sinking to a two-year low on Monday… ‘Many banks have been investing in WMPs to funnel money into the stock market,’ said Francis Cheung, head of China and Hong Kong strategy at CLSA… ‘It’s non-transparent, so I understand why regulators would try to act. But if this causes too much correction, then they will get worried. The No. 1 priority is to maintain a relatively stable stock market.’”
The truth of the matter is that Chinese officials these days have bigger concerns than stock prices. At this point, No. 1 priority should be stability for an incredibly bloated banking sector currently enveloped in “Terminal Phase” dynamics (i.e. it’s self-destructing). So-called “Wealth Management Products” (WMPs) have been a concern for several years now. And how did the timid regulatory approach play out in Bubbleland? From Bloomberg: “The outstanding value of China’s WMPs rose to 23.5 trillion yuan, or 35% of the country’s gross domestic product, at the end of 2015, from 7.1 trillion yuan three years earlier…”

“Terminal Phase” excess sees rapid expansion of increasingly risky Credit. A hypothetical graph of systemic risk grows exponentially skyward. Accordingly, the risk intermediation task turns burdensome and fraught with great risk. Somehow the financial sector must transform (Trillions of) increasingly risky loans into financial instruments with more appealing (money-like) attributes. Chinese “shadow banking” is an intermediation accident in the making, and it’s rational that spooked regulators would now target WMPs. It’s not clear how China at this stage can move to rein in egregious excess without inciting a tightening of financial conditions and resulting Credit and economic slowdown.

It was an interesting week in the markets. Global sovereign yields retreated back to within striking distance of recent historic lows. Gold jumped 2.2% and silver surged 3.6%. Yet copper posted a slight decline, while WTI crude sank 6.3%. Examining this week’s developments in Japan and China, as a trader I’d have greater concern for the global financial and economic outlook. It’s fascinating – as opposed to confusing - to watch gold and crude diverge. The yen bears – and dollar bulls – had the rug again pulled out this week. I see ongoing currency market volatility as a harbinger of general market instability. Sinking crude had high-yield energy debt under pressure, along with Mexican stocks and the peso. The Russian ruble declined 1.8% and the Colombian peso sank 4.1%. Equities were determined to retain their strong July gains, while the VIX holds confidently to the view that “whatever it takes” remains in firm control. Could be an interesting August.

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