BIS Annual Economic Report (for posterity)

Doug Nolan


With attention focused on unfolding trade wars and summer vacations, the release of the Bank of International Settlement (BIS) Annual Report garnered scant notice (with the exception of Gillian Tett's Thursday FT article, "Holiday Trading Lull Flashes Red for Financiers").

From the BIS: "It is now 10 years since the Great Financial Crisis (GFC) engulfed the world. At the time, following an unparalleled build-up of leverage among households and financial institutions, the world's financial system was on the brink of collapse. Thanks to central banks' concerted efforts and their accommodative stance, a repeat of the Great Depression was avoided. Since then, historically low, even negative, interest rates and unprecedentedly large central bank balance sheets have provided important support for the global economy and have contributed to the gradual convergence of inflation towards objectives."

As we near the 10-year financial crisis anniversary, I would approach back slapping with caution. The key issue today is not whether central bank post-Bubble reflationary policies avoided a repeat of the Great Depression. Rather, did the unprecedented concerted - and protracted - global central bank response increase the likelihood of a more destabilizing future crisis - one where the dark forces of global depression might prove difficult to escape?

I'm not interested in bashing the BIS. They strive to have a balanced approach. Yet reading through their insightful annual report it's apparent that major holes remain in the contemporary central banking analytical framework. To their Credit, they do recognize the unprecedented buildup of global debt and imbalances. In my view, however, they fail to appreciate how central bankers these days continue fighting the last war.

One of the report's five sections discusses "The financial Sector: post-crisis adjustment and pressure points." The theme is the successful implementation of concerted measures to boost the safety and soundness of the global financial system through increased bank capital and liquidity buffers. There is some attention to "asset managers," but for the most part potential financial risks are viewed through a traditional lens.

It's been my view, going back to 2009's aggressive reflationary measures, that central bankers failed to learn key lessons from the mortgage finance Bubble period. My biggest frustration revolved around the Fed's fateful decision to target mortgage Credit for system reflation - and then their complete neglect of prudent oversight of mortgage lending and mortgage-related financial intermediation, leverage and speculation. Indeed, they fashioned powerful incentives to borrowing, lend, build, speculate, leverage and intermediate risk - and then looked away.

Even as a self-reinforcing boom took hold, the policy mindset fixated on the nineties crisis period and the view that the Fed must move quite cautiously in removing accommodative measures. When the mortgage boom overheated, the Fed remained too timid to risk removing the punchbowl. Worse yet, as the Bubble inflated the markets turned increasingly confident that the Fed would resort to unconventional measures.

Over the past decade, global central bankers have incentivized risk-taking, speculation and leveraging in the securities and derivatives markets. Yet the so-called "macroprudential" focus has been on banking system capital, leverage and liquidity - fighting the last war. Ensure the securities and derivatives markets get all lathered up - and look away.

BIS: "At least until recently, global financial conditions remained very easy. In fact, they loosened further even as US monetary policy proceeded along its very gradual and well anticipated normalisation path… Importantly, credit spreads have been unusually compressed, often at or even below pre-GFC levels, and the corresponding markets appear to have become increasingly illiquid. Moreover, for most of the year under review the US dollar depreciated, supporting buoyant financial conditions especially in EMEs, which post-crisis have borrowed heavily in that currency and during the past year saw strong portfolio inflows."

The BIS report includes interesting data and charts. One of the more dramatic charts is "USD-denominated credit to EME non-bank borrowers," where EM dollar borrowings more than doubled since the crisis to a staggering $3.6 TN. "These trends mean the EMEs have become more exposed to an appreciation of the dollar and to reversals in international investors' risk appetite, as recent evens confirmed… Meanwhile, the greater participation of foreign investors in local currency markets compared with pre-crisis might not necessarily act as a stabilizing factor, as it may expose EMEs to a greater risk of capital flight."

I saw no reference in the BIS report to "hedge funds," "carry trades," or leveraged speculation more generally. I would be much less concerned if I believed actual investors were on the other side of historic EM debt growth.

For obvious reasons (i.e. their own data), the BIS doesn't partake in the fanciful notion of "deleveraging." "Public debt has risen to new peacetime highs in both advanced and emerging market economies." After ending 2007 at a problematic 179% of global GDP, debt over the next nine years rose to 217% of GDP. BIS data are broken into Advanced Economies and Emerging Economies. Not surprisingly, EM debt has led the charge during this cycle, having surged from 113% to 176% of GDP. No slouch, Advanced Economies debt has inflated from 233% to 266% of GDP.

BIS: "In some countries largely spared by the GFC, for quite some time there have been signs of a build-up of financial imbalances. This is because, in contrast to countries at the heart of the turmoil, no private sector deleveraging has taken place, so that the financial expansion has continued. The signs of imbalances have taken the form of strong increases in private sector credit, often alongside similar increases in property prices - the tell-tale sign of the expansion phase of domestic financial cycles, qualitatively similar to those observed pre-crisis in the economies that subsequently ran into trouble."

"Against this backdrop, a number of developments could lead to the materialisation of risks… In all of them, financial factors seem destined to play a prominent role, either as a trigger or as an amplifying mechanism. Indeed, the role of financial forces in business fluctuations has grown substantially since the early 1980s, when financial liberalisation took hold… One possible trigger of an economic slowdown or downturn could be an escalation of protectionist measures… A second possible trigger could be a sudden decompression of historically low bond yields or snapback in core sovereign market yields, notably in the United States… A third trigger could be a more general reversal in risk appetite…"

The BIS report includes an interesting section, "A Tightening Paradox?"

BIS: "In fact, until at least the first quarter of 2018, no tightening of financial conditions accompanied the normalisation of US monetary policy; it was only well into the second quarter that any appreciable tightening was seen, particularly in EMEs… From December 2015, when the United States started tightening, until late May of this year, two-year US Treasury yields rose in line with higher policy rates… But the yield on the 10-year Treasury note increased by only around 70 bps, while very long-term yields traded sideways. Importantly, the S&P 500 surged by over 30%, and corporate credit spreads narrowed, in the high-yield segment by more than 250 bps. The Federal Reserve Bank of Chicago's National Financial Conditions Index (NFCI) trended down to a 24-year trough last year before rebounding slightly this year, in line with several other financial condition gauges."

This section includes 12 separate bar charts comparing characteristics of the past three tightening periods, 1994/95, 2004/06 and "Current." To summarize, this cycle has seen the Fed raise rates less; bond yields generally rise less; stocks go up a lot more; high-yield spreads collapse like never before; investment-grade spreads narrow like never before; and local currency EM bond spreads collapse like never before. Perhaps most telling, the last chart shows $200 billion flowing into EM stocks and bonds during the current "tightening", up from about $40 billion and "NA" during the previous two cycles.

BIS: "There are several possible reasons for monetary policy's limited impact on financial conditions. These include factors unrelated to the policy itself, large and growing central bank balance sheets outside the United States, and possibly the gradual and predictable nature of the normalisation… The large-scale asset purchase programmes of the major central banks outside the United States may have offset the impact of the Fed's monetary policy normalisation… Finally, the gradualism and predictability of the tightening may also have played a role. Gradualism is especially called for when there is high uncertainty about the economic context and monetary transmission, as currently. In such a situation, this can help avoid undesirable financial and economic responses. Yet a high degree of gradualism and predictability may also dilute the impact of policy tightening."

"…Gradualism and predictability could induce search-for-yield and risk-taking behaviour, further compressing risk premia and boosting asset prices. Moreover, market participants could interpret gradualism and predictability as signalling that central banks wish to prevent sharp market moves, thereby providing implicit insurance for risky position-taking."

And this finds us closing in on a critical issue: After years of straying down the path of manipulating market perceptions and prices, it has turned into a monumental challenge to get markets to return to even a semblance of normal (self-adjusting and correcting) operations. History repeats. Once the Fed targeted mortgage Credit for post-"tech" Bubble reflationary measures, markets correctly presumed the Federal Reserve would adopt a hands-off approach. The Bubble would be left to inflate, with the Fed loath to risk popping a Bubble of its own creation - unwilling to quash progressively powerful asset market inflationary psychology.

Markets for years now have presumed central bankers would not dare risk popping global securities and derivatives market Bubbles. After all, the Bernanke Fed (followed by Draghi, Kuroda and others) specifically targeted inflating securities markets for system reflation. The Fed's ultra-gradualist approach to "normalization" has only worked to confirm the markets' faith that these Bubbles could run indefinitely. Gradualism has again fanned increasingly powerful market inflationary psychology. In the process, global markets became one unprecedented playground for leveraged speculation. Fed funds - securities speculation funding costs - remains below 2% in the U.S., while short rates are near zero or below for much of the world.

BIS: "The current backdrop for monetary policy normalisation is unprecedented in a number of important respects. Historically, interest rates in advanced economies, real and nominal, have never stayed this low for this long and central bank balance sheets have never swelled as large in peacetime. The long spell of multi-pronged policy accommodation may have left lasting marks on the macro-financial landscape, making policy effects harder to assess."

With equities rising on the initial day of Trump Tariffs (and retaliation), market pundits were proclaiming trade war risk was "already baked into stock prices." Wishful thinking, to be sure. From my vantage point, it was just another payrolls rally. Occurring on the first Friday of the month/quarter, the payroll data often spark an unwind of options positions maturing two weeks later.

The release of June jobs data corresponded with prospects for the first day of Trump Tariffs, ensuring ample hedging activity coming into Friday trading. And as the unwind of hedges spurred a market rally, pressure intensified on short positions more generally. The Goldman Sachs Most Short Index jumped (another) 1.4% Friday (up 3.4% for the week), again outperforming the general market. Betting against put buyers and short sellers has been a lucrative endeavor. But let's not mistake this speculative dynamic for sound fundamental underpinnings or healthy market behavior.

Trade wars appear poised to unfold over coming weeks and months, if not years. President Trump has threatened $500 billion of tariffs if China retaliates. China's initial response was measured. The game of chicken has commenced, although speculative markets are content to see minimal short-term economic risk. Surely, cooler heads will prevail. Nothing crazy prior to the midterms.

Meanwhile, Fed minutes presented a more hawkish FOMC, concerned by protectionist measures but increasingly focused on an overheated U.S. economy. Probably more interesting, there were some hawkish comments out of the ECB (Weidmann, Praet). This helped stabilize the euro (up 0.5%), with the weaker dollar spurring a relief rally in EM currencies, bonds and stocks. The rally in EM triggered the unwind of hedges and short covering in the U.S. and developed markets.

Not uncharacteristically, U.S. non-farm data evokes delusions of goldilocks. At this point, I doubt relatively contained wage growth will be holding the Fed back. Plus, the more important dynamics continue to unfold in overseas markets. China's Shanghai Composite sank another 3.5% this week, boosting y-t-d losses to 16.9%. China's CSI Midcap 200 dropped 5.1% and the CSI 500 small caps fell 4.2%. The ChiNext growth stock index sank 4.1%. Major indices in South Korea and Taiwan were both down better than 2%. Japan's Nikkei fell 2.3%. Copper sank 4.7%. Chinese real estate/apartment Bubble worries? In fixed income, German bund yields declined another basis point to a mere 29 bps. Ten-year Treasury yields fell four bps to 2.82%

It does not take a crazy imagination to envisage a global crisis beyond the scope of 2008/09. For one, Chinese and EM Bubbles barely missed a beat back then. A full-fledged global depression would require a synchronized global Bubble, replete with systematic Credit excess, economic maladjustment, and deeply systemic global imbalances. A backdrop conducive to fragility and crisis would include inflated asset markets on a global basis, policy-induced market misperceptions and egregious speculative excess. Well, it's all there.

I never bought into the 2008 vs. 1929 comparisons. The next crisis, perhaps. If you think the risk of a debilitating trade war is high today, just wait until Bubbles start popping. And is it reasonable to anticipate that countries actively engaged in heated trade disputes will empower their central bankers to quietly go off somewhere and develop a master plan for rescuing markets and the global financial system? Will swap lines between the Fed and PBOC be politically tolerable? It is a much more complicated world today than back in 2008.

We're approaching the 10-year anniversary of the "Great Financial Crisis." This fall will also be 20 years since the Russia/LTCM fiasco and the "committee to save the world." Too many committees, bailouts and reflations have nurtured just the backdrop for acute global financial, economic and geopolitical crisis. I wouldn't bet on central bankers being capable of maintaining control. Future historians might look back and identify this as a pivotal week. But will they appreciate that protectionism and trade wars are but a symptom? When will it be recognized that central banks are much more the problem than the solution?

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