Five Years of Whatever it Takes

Doug Nolan

July 25 – Bloomberg (Paul Gordon and Carolynn Look): “Five years ago today, Mario Draghi was talking about bumblebees. The European Central Bank president’s speech in London on July 26, 2012, became instantly famous because of his pledge to do ‘whatever it takes’ to save the euro. But for all the power and clarity of that phrase, he started his remarks more obliquely. ‘The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years. And now -- and I think people ask ‘how come?’-- probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis.’ At the time, the currency bloc was being buffeted by soaring bond yields in peripheral nations as speculators bet the union’s fundamental flaws would rip it apart. Draghi’s answer was to state unequivocally that the immediate crisis fell under the ECB’s responsibility and he would deal with it. ‘The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.’ That pledge was followed by a program to buy the debt of stressed countries in return for structural reforms, and in that respect the words alone proved to be enough. Yield spreads collapsed even though the program has never been tapped.”

This week marks the five-year anniversary of Draghi’s “whatever it takes.” I remember the summer of 2012 as if it were yesterday. From the Bubble analysis perspective, it was a Critical Juncture – for financial markets and risk perceptions, for policy and for the global economy. Italian 10-year yields hit 6.60% on July 24, 2012. On that same day, Spain saw yields surge to 7.62%. Italian banks were in freefall, while European bank stocks (STOXX600) were rapidly approaching 2009 lows. Having risen above 55 in 2011, Deutsche Bank traded at 23.23 on July 25, 2012.

It was my view at the time that the “European” crisis posed a clear and immediate threat to the global financial system. A crisis of confidence in Italian debt (and Spanish and “periphery” debt) risked a crisis of confidence in European banks – and a loss of confidence in European finance risked dismantling the euro monetary regime.

Derivatives markets were in the crosshairs back in 2012. A crisis of confidence in European debt and the euro would surely have tested the derivatives marketplace to the limits. Moreover, with the big European banks having evolved into dominant players in derivatives (taking share from U.S. counterparts after the mortgage crisis), counter-party issues were at the brink of becoming a serious global market problem. It’s as well worth mentioning that European banks were major providers of finance for emerging markets.

From the global government finance Bubble perspective, Draghi’s “whatever it takes” was a seminal development. The Bernanke Fed employed QE measures during the 2008 financial crisis to accommodate deleveraging and stabilize dislocated markets. Mario Draghi leapfrogged (helicopter) Bernanke, turning to open-ended QE and other extreme measures to preserve euro monetary integration. No longer would QE be viewed as a temporary crisis management tool. And just completely disregard traditional monetary axiom that central banks should operate as lender of last resort in the event of temporary illiquidity – but must avoid propping up the insolvent. “Whatever it takes” advocates covert bailouts for whomever and whatever a small group of central bankers chooses – illiquid, insolvent, irredeemable or otherwise. Now five years after the first utterance of “whatever it takes,” the Draghi ECB is still pumping out enormous amounts of “money” on a monthly basis (buying sovereigns and corporates) with rates near zero.

Keep in mind that while “whatever it takes” first radiated from Draghi’s lips, markets soon surmised that the ECB president was speaking on behalf of the cadre of leading global central bankers. After all, ECB (desperate) measures were followed promptly by the return of QE by the Federal Reserve, the Bank of Japan, the Swiss National Bank and others. It’s worth mentioning that the Fed’s balance sheet totaled about $2.8 TN in July 2012, only to rise to $4.4 TN by September 2014. Amazingly, Bank of Japan assets have expanded about three-fold since 2012 to approach $5.0 TN.

Going back to 2002, the burst “tech” Bubble was evolving into a full-fledged U.S. corporate debt crisis. Back then Fed governor Bernanke’s talk of “helicopter money” and the “government printing press” profoundly altered market dynamics. It may not have at the time been loud and clear. But putting markets on notice that the Fed was contemplating extraordinary reflationary measures was a far-reaching development for corporate debt. Facing a liquidity crisis back in 2002, Ford bonds had become a popular short in the marketplace. Almost single-handedly, Dr. Bernanke’s speeches proved a catalyst for the speculating community reversing the Ford (and corporate debt) bond short - and then going long. The impact on general market liquidity was profound. And with the corporate debt crisis resolved there was nothing to hold back the burgeoning mortgage finance Bubble.

What “Helicopter Ben” accomplished with U.S. corporate bonds, “Super Mario” surpassed with Trillions of European sovereign, corporate and financial debt. Italian bond yields ended 2012 at 4.5%, down 210 bps from July highs. Spain’s 10-yields declined about 250 bps to 5.00% in less than six months. “Whatever it takes” almost immediately transformed Italian and Spanish debt from favored shorts to about the most enticing speculative long securities in world.

Draghi’s utterance ‘The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough,’ was a direct declaration to speculators with short positions in the euro currency, along with shorts in Italian, Spanish and periphery debt. Immediately Cover Your Shorts and Go Long. Five years on, Italian yields hover around 2.10% and Spanish yields sit at about 1.50% - emblematic of arguably one of history’s most spectacular securities market mispricings. European bank stocks have gained better than 50%. Draghi not only bloodied the shorts, be ensured spectacular profits for those levered long European debt – and the riskier the Credit the greater the reward.

Central bankers should not be in the business of playing favorites in the markets. So how did it get to the point where they seek to incentivize longs (levered and otherwise) while routinely punishing the shorts? Because central bankers followed the Bernanke Fed into a policy course of using rising securities and asset prices as a reflationary mechanism for the overall economy. As we’ve witnessed now for going on a decade, that’s a slippery slope. Adopt pro-Bubble policies and there will be no turning back. Inflate an epic Bubble and you own it for the duration.

“The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does.” The euro flew and it soared incredibly high, trading above 1.50 to the dollar in early-2008. As fundamentally flawed as the euro monetary experiment has been, it was buoyed by the fundamentally weaker dollar. The euro flew on the back of highly speculative flows, much of it flowing from an overcharged U.S. Credit system. U.S. monetary policy had been too loose for too long. Unstable finance has been nurtured for what seems like an eternity. The U.S. exported its Credit Bubble to the world.

Going all the way back to the late-nineties, Italy and the European periphery were a leveraged speculator community darling. Indeed, the Euro Convergence Trade granted huge profits to the hedge fund community. The egregious amounts of leverage employed (directly and through derivatives) was illuminated with the 1998 implosion of Long-Term Capital Management (LTCM).

The LTCM fiasco contributed to an 18-month bear market that saw the euro trade down to 0.87 vs. the dollar in early 2002. With Dr. Bernanke and his radical theories on reflationary policies arriving on the scene in 2002, it’s no coincidence that the euro then embarked on a multiyear rally. The euro traded up to 1.00 late in 2002, 1.20 in 2003, 1.35 in 2004, 1.45 in 2007 and 1.58 in 2008. It’s furthermore no coincidence that Italian bond prices tracked the euro higher. After trading at 5.5% in the first-half of 2002, Italian yields dropped to 3.22% by October 2005. Greek bonds followed an almost identical trajectory, as both already highly-indebted nations took full advantage of the market’s insatiable demand for European peripheral debt.

Draghi has lately grown accustomed to patting himself on the back. He saved the euro. He saved Europe’s big banks. He kept Greece and Italy in the euro currency. His policies have spurred European economic recovery. But Draghi and global central bankers also inflated history’s greatest speculative Bubble. Celebration will be in order only if policies can be normalized without the whole thing coming crashing down.

July 25 – BloombergBusinessweek (Jana Randow): “Euro-area governments have saved almost 1 trillion euros ($1.16 trillion) in interest payments since 2008 as record-low European Central Bank rates depress bond yields at a time when state treasurers are also reducing debt. That’s according to calculations by Germany’s Bundesbank, which is urging finance ministers in the 19-nation region to make provisions for when interest rates start to rise. Italy, the world’s third-most indebted country, has benefited most, with savings exceeding 10% of gross domestic product.”

Italy has been the biggest beneficiary of collapsing market yields. The problem is that its debt load still expanded to a distressing 130% of GDP. Italy remains only a jump in yields away from trouble, and I suspect this helps explain why Draghi has been so reticent to pull back on the stimulus throttle. After trading below 1.90% in mid-June, Italian yields surged to 2.33% earlier this month as markets began to contemplate global central bankers moving toward concerted normalization.

The FOMC this week confirmed the dovishness of Yellen’s testimony before congress.

Apparently, over the past month Fed rate “normalization” has been scaled back to perhaps one more hike this year – and that could be about it. And I just don’t buy the Fed’s recent fixation on below target inflation (GSCI Commodities Index up 4.2% this week on further dollar weakness!).

Something has raised concerns at the FOMC. Could it be European debt markets, with ECB stimulus to be significantly reduced in the months ahead. Or perhaps it’s China and their officials determined to rein in some financial excess. EM and all their dollar-denominated debt? Maybe a dysfunctional Washington has supplanted international developments on the worry list – or, understandably, it could be a combination of things.

At least for the week, global markets lost a bit of their recent swagger. While Boeing helped the Dow to yet another record high, the S&P500 ended the week little changed. The broader market underperformed. The highflying technology stocks were unimpressive in the face of general robust earnings. The VIX rose to 10.29, with some volatility beginning to seep into stock trading. Commodities caught a big bid, while bond yields began moving north again. The currencies remain unsettled.

Thinking back five years, U.S. markets at the time were incredibly complacent. The risk of crisis in Europe was downplayed: Policymakers had it all under control. Sometime later, the Financial Times - in a fascinating behind-the-scenes exposé - confirmed the gravity of the situation and how frazzled European leaders were at the brink of losing control. Yet central bankers, once again, saved the day – further solidifying their superhero status.

I’m convinced five years of “whatever it takes” took the global government finance Bubble deeper into perilous uncharted territory. Certainly, markets are more complacent than ever, believing central bankers are fully committed to prolonging indefinitely the securities bull market. Meanwhile, leverage, speculative excess and trend-following flows have had an additional five years to accumulate. Market distortions – including valuations, deeply embedded complacency, and Trillions of perceived safe securities – have become only further detached from reality. And the longer all this unstable finance flows freely into the real economy, the deeper the structural maladjustment.

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