Bubbles, Money and the VIX

Doug Nolan

February 10 - Financial Times (John Authers): “The Importance of Bubbles That Did Not Burst:”

Is there really such a thing as a market bubble? I feel almost heretical answering this question. I and most readers have lived through two decades that were dominated by two vast investment bubbles and the attempt to deal with their consequences when they burst. Getting into definitions is beside the point. As US Supreme Court Justice Potter Stewart once said to define pornography: ‘I know it when I see it.’ And there is no point in arguing that the dotcom bubble that came to a head in 2000, or the credit bubble that burst seven years later, were not bubbles. I know a bubble when I see one, and they were bubbles. For those of my generation, spotting bubbles before they get too big, and thwarting them, seems to be vital for regulators and investors alike.”

“But in a great new compendium on financial history, several writers make the same points. The number of bubbles in history is very small. That makes it hard to draw any valid inferences from them. Further, definition is a real problem, and not just one for linguistic nitpickers. History’s acknowledged bubbles all have one critical factor in common; they burst. But that gives us a one-sided view. We need to look at those bubbles that did not burst and the crises that did not happen.


We’re at the stage where there’s impassioned pushback against the Bubble Thesis. To most, it’s long been totally discredited. Even those sympathetic to Bubble analysis now question why the current backdrop cannot be sustained. “The number of bubbles in history is very small.” Most booms did not burst. So why then must the current boom end in crisis - when most don’t? It has become fashionable for writers to try to convince us that such an extraordinary backdrop need not end extraordinarily.

There’s great confusion that I wish could be clarified. I define Bubbles generally as “a self-reinforcing but inevitably unsustainable inflation.” There are numerous types of Bubbles. Most definitions and research (as was the case with the analysis cited by the FT’s Authers) focus specifically on asset prices (“an extreme acceleration in share prices. In one version, [Yale’s Will Goetzmann] required them to double in a year — which excluded the dotcom bubble and the Great Crash of 1929. To keep them in, he also tried a softer version where stocks doubled in three years”).

Behind every consequential Bubble is an inflation in underlying Credit. My analysis focuses on the nature of the monetary expansion responsible for the asset inflation. I’m less concerned with P/E ratios and valuation than I am Credit expansions and the nature of risk intermediation. Earnings are important, but more critical to the analysis is the degree to which they (and “fundamentals” more generally) are being inflated by monetary factors - and whether such inflation is sustainable or susceptible.

Credit Dynamics are key. Mr. Authers refers to the “dot.com” and “Credit” Bubbles. Yet the nineties Bubble was fueled by extraordinary expansions in GSE Credit, securitizations and corporate debt. Internet stocks inflated spectacularly, but in the grand scheme of the Bubble were rather inconsequential. The Bubble faltered initially in 2000 with the sharp reversal in technology stocks. Less embedded in memory is the near breakdown in corporate Credit back in 2002. The resulting aggressive Fed-induced reflation then spurred a doubling of mortgage Credit in just over six years. The transformation of risky Credit into perceived safe money-like securities (“Wall Street Alchemy”) was integral to both “tech” and “mortgage finance” Bubble periods. The fact that dot.com price inflation and overvaluation greatly exceeded that of home prices is meaningless.

When I initially titled my weekly writings the “Credit Bubble Bulletin” back in 1999, I anticipated that “Bubble” would remain in the title only on a short-term basis. And indeed, I thought the Bubble had burst in 2000/2001 and then again in 2008. But in both instances Credit Dynamics and resurgent monetary inflation made it clear to me that a more powerful Bubble had reemerged. Whether one prefers to date the beginning of the Great Credit Bubble 1992, 1987 or even 1971, it’s been inflating now for quite a long time. Too be sure, the expansion of government Credit over the past eight years puts mortgage Credit and other excesses to shame. 
 
I would argue that price distortions and risk misperceptions similarly overshadow those from the mortgage finance Bubble period.

Of course, the vast majority have become convinced that the boom is sustainable. Indeed, analysis these days is eerily reminiscent of “permanent plateau” jubilation from 1929. The bullish perspective sees an improving global economy and a powerful pro-growth agenda unfolding in the U.S. Worries about debt, China and such matters have turned stale. A contrary argument focuses on Credit Dynamics and the unsustainability of today’s unique monetary and market backdrops.

Over the years, I’ve made the point that a Bubble financed by junk bonds would not create a systemic issue. There are, after all, limits to the demand for high-risk debt. Long before such a boom could go to prolonged and dangerous extremes (imparting deep structural maladjustment), investors would shy away from increasingly unattractive Credit issued in clear excess. The boom would lose its monetary fuel.

I define contemporary “money” as a financial claim perceived as a safe and liquid store of (nominal) value. Money these days is Credit, but a special type of Credit. Unlike junk bonds, “money” enjoys essentially insatiable demand. As such, a boom fueled by “money” is a quite different animal than our above junk bond example. I would posit that a prolonged inflation of perceived safe “money” by its nature ensures far-reaching risk distortions. For one, Bubbles fueled by “money” appear especially sustainable, while a prolonged inflation of “money” virtually ensures a destabilizing crisis of confidence. Governments throughout history have abused money. Contemporary central bankers took it to a whole new level.

I referred to the “Moneyness of Credit” throughout the mortgage finance Bubble period, a boom financed largely by “AAA” money-like MBS, ABS and “repo” Credit. Back in 2009, with the arrival of enormous expansions of central bank Credit and fiscal deficits coupled with the Fed’s reflationary policies targeting the securities markets, I proffered the “global government finance Bubble” and the “Moneyness of Risk Assets.”

I understand the rationality of complacency. I appreciate that confidence runs high that this boom need not end badly. Those willing to bet on central banks have won, repeatedly. “Money” – to the tune of Trillions – has flowed with great abundance to managers and fund structures programmed to disregard risk. The consensus view holds that huge amounts of buying power await a market dip. Moreover, only “dips” at this point would side against the mighty bull.

There’s no mystery why the VIX ended the week near ten-year lows. And I don’t believe, as explained by an analyst on Bloomberg television, that improved global economic fundamentals explain unusually low implied equities market volatilities (VIX). The VIX clearly does not reflect global political and geopolitical uncertainties. Instead, it’s more a reflection of robust global “money” and Credit growth and the perception that central bankers will ensure ongoing monetary inflation while backstopping global securities markets. With impatient dip buyers and central bankers not about to allow pullbacks to gain momentum, why not write put options and other derivative market “insurance”? Selling flood insurance during a drought. Central bankers have promised abundant liquidity and persistent loose financial conditions, while placing a floor under stock prices and a ceiling over market yields.

Returning to John Authers, when it comes to the current Bubble backdrop, I take exception to “I know it when I see it.” It’s the nature of Bubbles that the more conspicuous they appear the less systemic their impact. I point to the example of the conspicuous “tech” Bubble and much more systemic Bubble in “mortgage finance.” Even in the craziness of 2006 and early-2007, the truth of the matter is that few at the time recognized the Bubble.

Today’s Bubble is global, and it resides at the very heart of contemporary electronic “money.” 
 
This means, as we’ve already witnessed, that it can inflate almost indefinitely, at the discretion of a small group of central bankers and so long as their Credit is readily accepted. It’s unique in financial history, the consequence of the runaway global experiment in unfettered “money” and Credit. Even after tens of Trillions of issuance, the demand for central bank Credit (“money”) and (money-like) government debt is today as insatiable as ever. The downside is that this prolonged Bubble has inflated most assets across the globe. It has evolved to be deeply systemic on a global basis, with unprecedented distortions in risk perceptions and asset prices more generally.

There’s a reason why crises tend to erupt in the money markets. Panic quickly ensues when markets suddenly sense their perceived safe and liquid holdings are at risk. The VIX is low today because of the perception that global financial institutions remain flush with liquidity, buoyed by rising asset prices, and under the safekeeping of central bankers and government officials. The perception of moneyness pervades “repo” markets, and robust repo and securities financing markets convey easy access to liquidity for securities dealers and derivative players. 
 
The VIX is low because of extraordinary confidence in counterparties and the functioning of derivatives markets more generally. The VIX is low based on faith that Beijing will backstop China’s entire over-heated Credit system.

It’s worth recalling that a year ago bank stocks were under intense pressure around the world. 
 
For example, from 2015 highs to 2016 lows, Japanese stocks dropped almost 50%. Similar losses were shared by banks throughout Asia and Europe. Especially in early-2016, fears were mounting that a Credit crisis in China could unleash financial and economic stress around the globe. As a weak link in global finance, European banks were feeling the contagion. In short, there was heightened nervousness that risk was seeping back into the international daisy-chain of various bank liabilities. “Moneyness” – a now global phenomenon - was in jeopardy.

Well, “whatever it takes” – from strong-handed Chinese officials, from the inflationist BOJ and ECB, and from a dovish Fed - nipped potential crisis in the bud. Promises of a couple Trillion additional QE crushed global yields and kept the game going. Markets have inflated significantly over the past year. What will central banks do for an encore?

It is a principal thesis of Bubble Analysis that, once commenced, monetary inflations turn progressively difficult to control. Credit inflations raise myriad price levels throughout the economy and asset markets. Especially after years of inflating asset and securities markets, it will not be possible for global central bankers to walk away from QE without major consequences. The world is currently at peak QE, with major uncertainties surrounding future operations.

Europe, in particular, has begun to fret the effects of waning QE. I’ve highlighted the recent significant rise in sovereign yields in Portugal, Italy, Spain and Greece. I’ve noted the major widening of spreads between French and German bonds yields.

This week saw European bank stocks sink 2.4%. It’s worth highlighting the performance of the major French banks, with BNP Paribas (down 8.9%), Societe Generale (down 7.6%) and Credit Agricole (down 7.1%) posting notable declines. Italian Banks were slammed 5.1%, increasing y-t-d losses to 6.6%. UniCredit led the list of widening bank CDS, followed by Banco Santander and Intesa Sanpaulo.

Similarly concerning, European sovereign spreads continued to widened. Safe haven German bund yields dropped nine bps to a five-week low 0.32%. The France to Germany 10-year yield spread widened seven to 74 bps, the widest going all the way back to tumultuous 2012. Italy’s spread widened 10 to 195 bps, trading this week at the widest level since early-2014. Spain was 11 wider to 138 bps, the widest since last June.

U.S. bank stocks also lagged this week’s market rally. But with Chinese and Asian banks enjoying strong gains, it might be too early to make much out of the return of European bank concerns. Yet it does have to start somewhere. ECB policies have encouraged Europe’s banks to (again) load up on government bonds at incredibly inflated prices. Now what?

Here in the U.S., markets this week took comfort in a relatively well-contained President Trump. He greeted Japanese Prime Minister Abe with a big, warm hug. He sent a letter to Chinese President Xi, stating that his Administration would honor the “One China” policy. 
 
While perhaps somewhat mollified by his correspondence, Chinese leadership must be deeply suspicious of Trump’s zeal for chumming around with Shinzo (Abe). But at least for now, our President was trying to get along with (most) folks. Markets got along well with the idea of “phenomenal” tax cuts. 

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