McAlvany Wealth Management Client Conference
Doug Nolan
Adapted from my Friday, October 7, 2022, presentation at the annual McAlvany Wealth Management Client Conference in Durango, Colorado.
I fell in love with macro analysis sitting at a trading desk staring at Telerate and Quotron screens in the summer of 1987 – wild global market instability that culminated that October with the “Black Monday” crash.
Little did I know at the time that it would be the first of many crises I would witness, analyze and reflect upon.
There were the S&L and banking crises in the early nineties; the 1994 bond market and derivatives crisis; the Mexican ‘tequila’ crisis in ’95; the devastating Asian Tiger Bubble collapses in ’97; the LTCM/Russia debacle in ’98; the bursting tech bubble in 2000; 9/11; the 2002 corporate debt crisis; the collapse of the mortgage finance Bubble in 2008; the 2011/2012 European debt crisis; and the 2020 pandemic crisis – just to name the most consequential.
But I’ve seen nothing in my career as alarming as today’s environment – and it’s not even close.
My analytical framework has been a work-in-progress for 35 years.
I’ll note two particular facets of my experience that have been especially valuable.
I am a CPA by training.
My accounting education at the University of Oregon was rigorous and invaluable, as was my stint at Price Waterhouse.
I have a passion for monetary theory – but I always view money and credit through the lens of debits and credits.
Finance is, after all, one vast global electronic general ledger.
Second, after graduate school, I accepted a position with Gordy Ringoen’s bearish hedge fund in San Francisco.
We were up 63% in 1990.
We were the geniuses – turning away investors.
I’ve talked about this in the past.
I remember sitting at my desk daydreaming about what it was going to be like for this small town working class kid to become wealthy.
And let me tell you, there is nothing that could have gotten me more focused and determined than to watch my hopes and dreams get absolutely crushed.
I owe my perspective and analytical framework to my obsession during the 1990s of trying to understand how a bear market, a severely impaired banking system, and deep economic recession morphed into one of history’s great bull markets and economic booms.
Early on, I became focused on non-bank Credit creation – asset-backed securities, mortgage-backed securities, commercial paper, money market funds, the big brokerages, the repo market, Wall Street structured finance…
And in 1994, I watched as the government-sponsored enterprises – Fannie, Freddie, and the FHLB – provided huge liquidity injections to accommodate hedge fund deleveraging.
They were operating as quasi-central banks, and no one seemed to care but me.
The GSEs were again providers of enormous liquidity during the 1998 crisis, and then in 1999 and 2000.
By the late-nineties, I was convinced that finance had fundamentally changed.
It was out with the traditional bank-dominated Credit system – restrained by bank reserve and capital requirements.
Meaning there were mechanisms that at least placed some boundaries on lending and Credit expansion.
This new non-bank Credit was completely unfettered.
The GSEs and Wall Street finance, in particular, basically operated without any constraints whatsoever.
From my study of history, I had become convinced that Credit was absolutely key to boom and bust and Bubble dynamics.
First and foremost, Credit is inherently unstable.
Credit begets more Credit and Credit excess ensures only greater amounts of destabilizing Credit excess.
I looked at this new Credit structure and the acute instability in ‘93, ‘94, ‘95, ‘97, ‘98, and then the almost doubling of Nasdaq in 1999 – and it was clear to me this new financial structure was a disaster in the making.
I would explain my analysis to anyone who’d listen.
And, let me tell you, no one was interested in listening.
I expected the Federal Reserve would come to better understand this highly unstable Credit mechanism and move to rein it in.
I spoke with Fed officials, economists, financial journalists and other market professionals, and basically everyone told me I was wrong.
You know, looking back years later – my analysis WAS dead wrong on something critically important.
I thought this new finance was part of a late-cycle phenomenon that emerged after the ’87 crash.
Instead, it was the dawn of historic Credit, speculation, economic and policy cycles.
I was actually right about the monumental evolution in finance in the nineties.
Yet it was not until Pimco’s Paul McCulley in 2007 referred to the new “shadow banking” system that people began to take notice.
By then, it was far too late.
The genesis of my analytical mistake can be directly traced to central bankers – and it is most pertinent to today's predicament.
As I mentioned earlier, I thought the Fed would respond forcefully when they understood the instability of market-based finance.
Clearly, I was young and naive.
They did the exact opposite.
They accommodated it, and over a couple of decades remade central bank policy doctrine to nurture, protect, rescue and revitalize this new financial structure.
So, I’ve dedicated my Friday nights for the past 24 years to chronicling the evolution of finance and policymaking and the inflation of the greatest Bubble in the history of mankind.
I’m here today with what I believe is a critically important message.
The global Bubble – history’s greatest Bubble - is bursting.
The previous cycle has ended, and a new cycle has begun to unfold.
We are about to commence an adjustment period that I fear will shake us to the core.
I am reminded of a passage from a book I read some years ago.
The author had interviewed Wall Street traders following the 1929 crash – asking them how they could not have seen peril coming.
How could they have missed the egregious amounts of broker call loans, all the debt, the speculative excess, and market and international fragilities?
Interestingly, their responses were consistent.
They were all aware of the key issues – but they said they were fearful in 1927, and when operating in the markets you can only remain frightened by things for so long.
There’s another quote from that era that has always resonated.
“Everyone was determined to hold their ground, but the ground gave way.”
At this point, we’ve become numb to all the excess – excessive debt, speculative excess, reckless monetary inflation and policymaking.
My sense is that in the markets, within the business community, throughout the country, we know there are serious issues.
Yet individually, we’re all determined to hold our ground.
Right now, I sense a major global earthquake.
There are multiple fault lines.
The ground is giving way in China.
The ground is giving way in Europe.
The emerging markets are fragile.
Japan is an accident in the making.
And these various fault lines are linked.
A deep complacency settled in here in the U.S.
Most believe we are largely immune to global maladies.
The view persists that the Federal Reserve has everything under control.
Analytically, there are interrelated Bubbles globally that essentially create one monumental Bubble.
Why do I suggest a singular Bubble?
Because of interconnectedness and commonality – because of similar structures.
There are similar policy regimes.
The world essentially adopted inflationary Federal Reserve doctrine – low rates, QE, and market interventions and backstops.
Similar market structure – in particular derivatives, swap markets, leverage and speculation.
Importantly, virtually the entire world readily adopted so-called “Wall Street finance.”
And “whatever it takes” central banking became deeply embedded in market perceptions and prices everywhere.
Interconnectedness: trading systems, derivatives platforms, swaps trading, hedge funds and “family offices”, international mutual fund complexes, inflationary policies…
Moreover, over the long boom, international finance became one fungible, commonly shared pool of liquidity – too much of it trend-following, levered speculative finance.
And now, with Bubbles faltering and global financial conditions tightening, I believe global policymakers have lost control of Bubble dynamics.
Clearly, they don’t control inflation dynamics.
I believe we’re witnessing a secular change in pricing dynamics and inflation psychology.
Moreover, I believe the previous cycle of relatively tame consumer price inflation in the face of massive monetary inflation was aberrational.
I won’t delve into details today, but a unique confluence of developments – globalization, the rise of China, technological innovation, financial asset inflation and speculative Bubbles – all worked to repress consumer prices.
Today’s new cycle, with global fragmentation and the new iron curtain, deep-rooted supply chain issues, commodities supply/demand imbalances, climate change issues and the like, ensures very different inflation dynamics going forward.
Indeed, surging inflation is forcing the Fed into the first real tightening cycle since 1994 – 28 years ago.
And since 1994, markets – rather than inflation – have been the Fed’s priority.
Now, the powerful revival of traditional inflation dynamics has dictated an abrupt shift in focus and priorities.
While early in the process, the Fed is being forced to revise doctrine back to more conventional central banking.
We cannot overstate the significance of the so-called “Fed put” during the previous cycle.
This liquidity backstop – that morphed over time into “whatever it takes”, zero rates and endless Trillions of QE – created the perception of safety and liquidity - of “moneyness” - throughout the financial markets.
Stocks became a can’t lose, corporate debt the same, and even the crazy cryptocurrencies.
Can’t lose included derivatives and Wall Street structured finance – private equity, venture capital, hedge funds and leveraged speculation.
With central bank backing, perceptions crystallized that the entire new financial structure was a can’t lose.
And this “moneyness of everything” was paramount to synchronized late-cycle Bubble “blow-off” excess across the globe, with historic misperceptions fundamentally changing how markets and financial structures function – market pricing, speculative dynamics, risk management, and the overall flow of finance.
History offers nothing remotely comparable.
These days, it’s increasingly apparent that the world has changed, and this is at the heart of unfolding new cycle dynamics.
Central bankers have been jolted – their policies, their doctrine, their views of how the world works.
Importantly, their market liquidity backstops have turned problematic and ambiguous.
In the end, I believe central banks will have no alternative than to employ additional QE to counter the forces of bursting Bubbles.
For now, inflation’s resurgence suggests the halcyon “money” free-for-all days are behind us.
Back during the 1987 crash, so-called “portfolio insurance” played a meaningful role in the avalanche of sell orders that crashed the market.
I then watched as derivatives were instrumental in market crises in 1994, ’95, ’97, ‘98, 2000, 2008, 2011, and 2020.
And with each central bank market bailout, the monstrous derivatives Bubble inflated to even more dangerous extremes.
Peter Bernstein’s classic book, “Against the Gods: The Remarkable Story of Risk,” was published in 1996.
It’s a masterpiece, though I’ve always had an issue with the notion that we live in an enlightened age where risk can be better understood and managed.
Over the past cycle, the view took hold that central banks can control market risk, while derivatives offer an inexpensive and reliable mechanism to mitigate risk.
I don’t believe we can overstate the role derivatives have played – within the markets, but also throughout the real economy.
They’re ubiquitous – institutions, corporations, investment managers, and even individual investors all fell in love.
I’ve already seen ample evidence that derivatives will be at the epicenter of unfolding financial crises.
They’re certainly worthy of keen analytical focus.
There are serious fallacies embedded in the derivatives universe that I expect to be revealed with major consequences.
First, derivatives operate under the assumption of liquid and continuous markets.
Meaning, derivatives players assume they’ll always be able to buy and sell in orderly markets to hedge exposures to contracts they’ve written.
Yet centuries of history are unequivocal: markets invariably suffer through bouts of illiquidity, discontinuity, panics and collapses.
So, how have derivatives markets flourished for three decades, quickly recovering from multiple crises?
There’s one simple answer: central banking and the evolution of market backstops – more recently to the point of absolutely egregious monetary inflation.
Keep in mind how things operated over the past cycle: Loose money would fuel a Bubble, the Bubble would burst, and only looser money restored Bubble dynamics to fuel the next even bigger Bubble.
This cycle repeated to the point of an insane $5 TN pandemic QE onslaught, stoking the so-called “everything Bubble” and history’s greatest mania.
Over the past decade, not only did the “granddaddy of all bubbles” go global, it also infected the foundation of finance – central bank Credit and government debt.
With consumer price inflation now a serious issue for central bankers, tighter monetary policy is hitting a dangerously fragile world.
Myriad Bubbles are faltering outside central bank control, and evidence is mounting that global policymakers have lost the capacity to ensure liquid and continuous markets.
As such, we have to question whether colossal derivatives markets, as we’ve known them, will be viable in the unfolding environment.
Buying inexpensive market insurance has been fundamental to so many strategies.
It has been central to leveraged speculation and risk-taking more generally.
If insurance is readily available and cheap, why not take on more risk and leverage?
And this gets back to derivative market fallacies.
The fundamental issue is that market losses are uninsurable.
Insurance companies provide protection against random and independent events.
Years of actuarial data create the ability to accurately forecast and price for future losses - for automobile accidents, house fires, healthcare expenses, death and so on.
Insurance companies price policies and hold reserves for expected future claims.
Market losses are categorically neither random nor independent.
They come in waves, with unpredictable scope and timing.
Moreover, those that sell market protection do not build reserves against future losses.
Instead, they use sophisticated trading programs and buy and sell instruments in the marketplace to provide the necessary cashflow to pay on derivatives written.
In particular, when a derivatives dealer writes market protection, the strategy dictates they sell instruments into a declining market to ensure they have the resources to pay on losses.
This creates the clear potential to unleash cascading sell orders and a market crash.
And we’ve seen this play out repeatedly, from “portfolio insurance” back in 1987 to just last week’s near crash of the UK bond market.
Recall also how in March 2020, the Fed had to announce several announcements of ever larger QE programs to finally stem the waterfall of sell orders – in stocks, bonds, and ETFs shares.
The Fed resuscitated the bubble, with speculative excess and leverage growing only more problematic.
And the greater the scope of market risk, the more dangerous derivatives become.
There’s a perception these days that it’s possible to just buy derivative insurance and lock in gains from the great bull market.
Economists of old referred to the “fallacy of composition.”
Simplistically, what works for one individual has much different consequences if adopted by the group.
Right now, I think much of the marketplace believes it can use derivatives to mitigate market risk.
Yet it’s impossible for the broader market to hedge against losses.
There’s simply no place to offload tens of Trillions of market risk.
No one has the wherewithal to absorb such losses.
And if a large segment of a market hedges risk in the derivatives marketplace, those hedges create systemic crash risk.
If the market breaks to the downside, the writers of this market protection will be forced to aggressively sell into a collapsing market.
If not for QE, derivative markets would surely have collapsed in both 2008 and 2020.
And, again, this is not some theoretical proposition.
This dynamic unfolded last week in the UK gilt market.
Aggressive Bank of England intervention thwarted a market collapse, but in the process market fragilities were revealed.
Over the years, I’ve shared a flood insurance analogy.
Picture a sleepy little village on a pristine river, where a long drought encouraged local insurance companies to write a few policies for waterfront development.
As the drought lingered, more entered the flood insurance market to capture some of the easy profits. Building along the river started to boom.
Of course, many wanted in on the action, with new insurance operators sprouting up on every corner.
Curiously, they actually had no intention of ever paying a claim.
They were writing policies and immediately booking the profits, with the plan of moving quickly to offload exposure in the bustling reinsurance market in the unlikely occurrence of torrential rainfall.
The moral of this story is that an extended period of tranquility – a long drought – distorts risk perceptions and market prices, while inviting destabilizing speculation.
Effects are both financial and economic.
It’s a sad tale, unfortunately, as when torrential rains finally arrived, the crowd of insurance speculators rushed to offload their risk.
Panic ensued.
There was no one willing and able to write policies, and the reinsurance marketplace collapsed in illiquidity.
Importantly, the amount of lavish building all along the river had risen exponentially – all because of the insurance market Bubble.
After the flood, scores of so-called “insurance companies” collapsed, and most policies were worthless.
Pondering the current environment, I’ve updated my analogue.
After the first flood, the local government bailed out the insurance companies, built a dam up river, and handed out a lot of money for local residents to rebuild.
Eventually, however, the dam proved incapable of holding back the water.
There was another flood, a bigger bailout and only more generous handouts.
After multiple rounds of this over a few decades, everyone came to believe risks could simply be ignored.
Just build your dream home and place your faith with local government officials.
Complacent townsfolk were oblivious to a momentous predicament.
The government had reached its limit in holding back the water.
There was no place on the river for additional barriers, and serious structural issues made it too risky to continue to add to the height of existing dams.
Understandably, the attention of local officials shifted from supporting insurance and building booms, to the myriad structural issues and risk of a catastrophic domino dam collapse.
The ending of this tale has yet to be written.
Do the townsfolk start losing confidence in the local government’s capacity to sustain the boom?
Do the townspeople realize there’s no capacity for additional dams?
Do they worry about the insurance companies and their policies?
One thing’s for sure, the rainfall is unrelenting, and all the dams have reached maximum capacity.
Importantly, the boom reached a point where confidence turned fragile – confidence in the local government - confidence in the insurance market, as well as the economy.
The reinsurance market began to malfunction, forcing the speculators to back away.
Flood insurance became increasingly difficult to get and more expensive.
Even before the rains, the building boom faltered.
The message from my update: Perceptions can change with enormous ramifications.
After years of good times, the townspeople came to believe the local government had control of the river flow.
Heck, many thought they could control the weather.
Some refer to a “Lehman” or a “Minsky moment.”
I call it the “holy crap moment”.
Suddenly, things are not as we thought; they might be spiraling out of control, and our government benefactor no longer has the answer.
I look at the world today and see things spiraling away from the control of central bankers and policymakers.
China’s historic bubble is collapsing.
One of history’s great speculative manias – Chinese apartment units – has begun the crash phase.
And while China’s spectacular Credit Bubble continues to inflate, even egregious amounts of new Credit are not enough to sustain the boom.
Chinese bank assets reached $55 TN this year, after beginning 2009 at about $9 TN.
It’s frightening to ponder the quality of Chinese bank assets.
We’ve already witnessed a spectacular Chinese developer bond collapse – an industry with several trillion dollars of liabilities.
China also has serious Credit issues with multi-trillion local government debt instruments and the multi-trillion AMCs, or “asset management companies” created to clean up after the nineties bust.
Importantly, the Chinese currency is showing vulnerability, down over 10% y-t-d versus the dollar.
Country Garden, China’s largest builder, only months ago viewed as a sound Credit, saw its bond yields today surge to a record 53%.
China would already be in full-fledged financial crisis, if not for one thing: There's still faith that Beijing controls the weather.
Europe faces war, an acute energy crisis, a tumultuous winter, high inflation, recessionary forces, and major debt issues.
Yet so far faith holds that the ECB still controls the weather (“Believe us, we control the weather”).
European peripheral debt markets are a fragile fault line.
When yields spiked in June – even in the face of zero rates and ongoing QE – the ECB concocted a so-called “anti-fragmentation tool” for purchasing periphery bonds in the event of a disorderly yield spike.
Bond yields reversed sharply lower on the news, but now are right back near June highs.
Italian yields spiked 23 bps Wednesday – and are up 18 bps today - on a Moody’s warning of an Italian debt downgrade if the new right-wing coalition government doesn’t stick with spending commitments.
Truth be told, the ECB really doesn’t want to use its anti-fragmentation tool.
If they employ it and it flops, they immediately face a serious crisis of confidence.
And what’s at stake is nothing short of European monetary integration and the survival of the euro currency.
I’ve had a long-held view that, at the end of the day, I don’t expect the Germans and Italians to share a common currency.
An unfolding periphery debt crisis risks financial, economic, social and political crises.
Let’s shift to Japan.
I have tremendous respect for the Japanese people.
They endured a bursting Bubble and prolonged stagnation.
As a society, they held things together.
For years, I even defended Japanese policymaking.
While they terribly mismanaged monetary policy during their Bubble period, they got through the downturn without resorting to reckless monetary inflation.
The yen remained strong.
But then Ben Bernanke convinced the Bank of Japan to start printing money and, predictably, they’ve not been able to wean themselves from rank inflationism.
The Bank of Japan went so far as to continue enormous monetary inflation as part of a policy to place a 25 basis point ceiling on 10-year government yields.
The yen has sunk to a 24-year low, and the Japanese are paying a lot more for a lot of things.
I fear Japan is another accident in the making.
In a world of surging inflation and spiking market yields, markets are questioning how long the BOJ can continue manipulating the weather.
I fear the dam will break when the BOJ yield peg collapses.
Emerging markets are always vulnerable to tightening financial conditions.
The high-risk periphery is notoriously on the receiving end of “hot money” speculative flows during Bubble periods, but then faces crisis dynamics when “risk off” deleveraging spurs illiquidity and dislocation.
Crisis dynamics have been in play, but so far this cycle has some nuance.
This was a most protracted global Bubble period, and over the years EM countries built significant dollar reserves.
These reserves have provided firepower for EM central bankers to stabilize their currencies, which has underpinned general confidence.
But EM countries are rapidly burning through these reserves, and a crisis of confidence appears unavoidable.
Moreover, when EM central banks sell reserves, such as Treasuries, to bolster their currencies, this puts upward pressure on Treasury and global yields.
It’s a “doom loop”.
Eastern European nations face obvious risks.
Asian emerging market economies are over-levered and acutely vulnerable to the confluence of tightening financial conditions and Chinese and Japanese crises.
Latin America is always vulnerable, with a critical Brazilian presidential election only a few weeks away.
I worry these fragile global fault lines – China, Europe, Japan, EM and others – are poised to succumb in unison.
And in no way do I believe the U.S. is immune.
No market experienced comparable speculative excess.
No economy feasted so on years of essentially free “money”.
U.S. market structure is acutely vulnerable.
Our economic structure is extremely vulnerable to tightened Credit and liquidity conditions.
In particular, the long boom period saw a proliferation of uneconomic, negative cash-flow businesses and enterprises.
In Austrian Economics parlance, it’s been epic malinvestment.
And in no country has there been such faith that the central bank has everything under control – that it controls the weather.
The problem today is that the Fed faces a serious inflation problem.
Our central bankers appreciate that financial conditions must tighten before price pressures and inflationary psychology spiral out of control.
Meanwhile, our entire financial structure has been underpinned for years by the perception that the Fed will do “whatever it takes” to support the markets and grow the economy.
The view holds that the Fed won’t allow a crisis.
It will cut rates and deploy as much QE as necessary to thwart financial crisis.
But there’s a big problem: The Bubble has inflated to the point that it will take Trillions of additional QE to accommodate a serious de-risking/deleveraging.
Recall how it required several Fed announcements of additional massive QE to thwart market collapse in March 2020.
Five Trillion of QE later, the Bubble had grown only bigger and more unwieldy.
And the inflation problem is much more severe and deeply rooted.
This means the Fed liquidity backstop has turned uncertain.
I expect more QE, but the Fed will respond more slowly and cautiously.
And I do not expect this to suffice in the markets.
There are many myths and misperceptions at stake.
And I fear the “holy crap” moment – markets hit with the harsh reality that the Fed and global central bankers don’t have everything under control.
In particular, I fear concurrent crises of confidence in policymaking and market structure.
De-risking/deleveraging will feed illiquidity and market dislocation. Global derivatives markets will be severely tested.
I’ll also briefly speak to today’s alarming geopolitical backdrop.
The Ukraine war, deteriorating relations with China, Taiwan, North Korea, Iran and such.
Why are so many things coming to a head right now?
Keep in mind that boom periods engender perceptions of an expanding global pie.
Cooperation, integration and alliances are viewed as mutually beneficial.
But late in the cycle, perceptions begin to shift.
Many see the pie stagnant or shrinking.
Zero sum game thinking dominates.
Insecurity, animosity, disintegration, fraught alliances and conflict take hold.
I see no end in sight for the extremely challenging market environment.
We’ll have to continue to navigate through de-risking/deleveraging dynamics and chaotic market instability.
The extraordinary environment demands intense daily focus, discipline, and a risk-management focus.
It is time to be on alert and as prepared as possible.
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