Faltering "Financial Sphere"
Credit Bubble Bulletin, by Doug Noland
May 7, 2004
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U.S. Financial Sphere Bubble Watch:
Moments after the release of Tuesday’s FOMC statement, CNBC’s Ron Insana put a question to Pimco’s astute Bill Gross: “From an investor’s perspective, what do you do in the bond market as a consequence of what the Fed decided and said today?”
Mr. Gross’s interesting response: “Well, I think you begin to sell them. You know, if the market is still rallying, that’s what I’m going to do in the next five to 10 minutes. What the Fed has done is what I told you they were going to do. They are trying to sedate the bond market, to attach this measured upward movement in Fed funds to the containment of inflation. I would argue that inflation is not contained. Twenty to twenty-five percent increases in housing in California and elsewhere; commodity indices at all-time record highs; a CPI that in the next month or two, on a 12-month basis, will approach 3%. That’s not containment of inflation. So, a bond investor should sell this rally if it’s still going on to this minute and move money elsewhere to a central bank in Euroland that is more rational.”
Well, with today’s 288,000 gain in April payrolls (625,000 in two months!), much more than a promise of “measured” Fed rate increases is now required to sedate The High-Anxiety Bond Market. Strong job gains, understandably, now have interest-rate markets panicked that a full-fledged economic boom is in the works. For some time, the nation’s housing and construction markets having been booming, the service sector has been booming, consumption has been booming, government spending has been booming, and even the hollowed manufacturing sector has been in a strong recovery. And while massive monetary and fiscal stimulus was fostering an especially unbalanced (and unsound) boom at home and abroad, the Fed and, hence, the bond market were willing to ignore the general environment and fixate on comforting jobs stagnation. No more.
This has been an extraordinary 18 months of reflation. It has been powerful as well as conspicuous. Prices of about everything – real and financial, at home and abroad - were pushed higher by truly unprecedented global credit and speculative excess. Yet the Greenspan Fed clung stubbornly to its flawed analytical framework – the same one that created the boom and near-bust they have of late been so determined to rejuvenate. Of all the indicators of the monetary environment, they chose one of the few not demonstrating a strong inflationary bias (employment - held in check largely by the unbalanced nature of the boom and an uncompetitive U.S. cost structure). It is a most unfortunate case of following previous errors with only greater blunders. And now the bond market is providing important confirmation that the Fed has sacrificed a lot of credibility along the way. As much as the Fed wanted to lead, they will now have no choice but to follow the markets.
It’s been quite a party, and the Fed now clearly has its hands full as it attempts to restore order. And while the Fed is determined to avoid a replay of 1994, the markets are well on their way. Yields are surging across the globe, and The Great Reflation Trade of 2003 is coming unglued. Derivative markets have quickly come under heightened stress. U.S. bonds are being crushed; MBS crushed; and various interest-rate speculations crushed. I even read market analysis that speculated that the GSEs were selling mortgage-backeds. Oh lord. And the emerging markets are turning into a rout - equities, debt and currencies all being aggressively liquidated. The “commodity currencies” and some commodities are under heavy selling pressure as well. All the previously “hot trades” are turning to dry ice.
Tuesday, bond futures traders were said to have booed when the Fed missed yet another opportunity to get the rate increase cycle underway. In many respects, we would be so much better off if this process would have commenced last year. And the more the Greenspan Fed works to assuage the marketplace, the farther out of step with reality it finds itself. Considering the unfolding environment, I found yesterday’s speech from Mr. Greenspan – Globalization and Innovation – especially pertinent (and in some cases ironic).
From Greenspan: “The United States economy appears to have been pressing a number of historic limits in recent years without experiencing the types of financial disruption that almost surely would have arisen in decades past. This observation raises some key questions about the longer-term stability of the U.S. and global economies that bear significantly on future economic developments, including the future competitive shape of banking… Has something fundamental happened to the U.S. economy and, by extension, U.S. banking, that enables us to disregard all the time-tested criteria of imbalance and economic danger? Regrettably, the answer is no. The free lunch has still to be invented. We do, however, seem to be undergoing what is likely, in the end, to be a one-time shift in the degree of globalization and innovation that has temporarily altered the specific calibrations of those criteria. Recent evidence is consistent with such a hypothesis of a transitional economic paradigm, a paradigm somewhat different from that which fit much of our earlier post-World War II experience. Globalization has altered the economic frameworks of both advanced and developing nations in ways that are difficult to fully comprehend. Nonetheless, the largely unregulated global markets, with some notable exceptions, appear to move effortlessly from one state of equilibrium to another. Adam Smith’s ‘invisible hand’ remains at work on a global scale. Because of a lowering of trade barriers, deregulation, and increased innovation, cross-border trade in recent decades has been expanding at a far faster pace than GDP. As a result, domestic economies are increasingly exposed to the rigors of international competition and comparative advantage. In the process, lower prices for some goods and services produced by our trading partners have competitively suppressed domestic price pressures.”
It is my sense today – from both a day-to-day market analyst perspective as well as one of a more macro economic and financial “theorist” – that we must be especially mindful to partition our analysis of the financial and economic “spheres.” For Mr. Greenspan (the ideologue), it comes naturally to follow a sentence addressing “globalization” with others trumpeting “unregulated global markets” and “Adam Smith’s ‘invisible’ hand” “at work on a global scale.” He speaks of paradigm and structural shifts where he melds technological advancement and changes in economic structures with financial innovation. He speaks of moving “effortlessly from one state of equilibrium to another.” The end result, apparently, is a global environment demonstrating “a notable decline in world economic volatility.” “In tandem with increasing globalization, monetary policy, to most observers, has become increasingly effective in achieving the objectives of price stability.”
From my analytical framework, I come up with a quite different analysis and a profoundly divergent conclusion. The past two decades have witnessed truly incredible technological advancements, while “globalization” (Greenspan’s definition: “The extension of the division of labor and specialization beyond national borders.”) has significantly increased the capacity to produce low-cost goods. (The period following the first World War and concluding with the 1929 stock market crash provides a disconcerting historical parallel.) But the paramount Greenspan Fed’s error – invited by a fixation on “productivity” and the downward price pressures exerted by the manufactured goods and technology arenas (“economic sphere”) – was to relax and nurture historic innovation, expansion, speculation and general self-reinforcing excess throughout the “financial sphere.”
And while I can contemplate paradigm shifts in the underlying structure of economies, I in no way subscribe to fanciful notions of New Age Finance. Two decades of unprecedented financial deregulation, innovation, and expansion have fostered the classic manifestations of destabilizing speculation, gross over-leveraging, and financial and economic Bubbles. The more things change, the more they stay the same. And it has been the unappreciated “grease” of unprecedented credit and liquidity creation that has fueled booms and busts, as well as having provided the almighty capacity to provoke additional booms to mitigate the fallout from the preceding busts.
Mr. Greenspan often refers to the great “efficiency” of contemporary global finance. He has repeatedly trumpeted the virtues of derivatives and gone so far as to exalt the liquidity-creating capacity of hedge fund finance. Just yesterday he again blessed hedge funds, derivatives and the “advent of a number of different intermediary institutions” that are taking risks that in the past would have been left almost exclusively to banks.
I am convinced that the central flaw in the Fed’s viewpoint is to misinterpret an historic expansion in leveraging and speculating for sound and sustainable “financial innovation.” During more than a decade of repeated global financial and economic crises, the Federal Reserve and global central bankers have successfully perpetuated the global financial Bubble. The Fed, in particular, has aggressively manipulated interest rates and the yield curve to incite leveraged speculation. The consequence has been a massive leveraged speculating community that has evolved into the key monetary transmission mechanism – the leading source of liquidity for financial markets and economies. Over the past 18 months, this “mechanism” has created global liquidity like never before.
As one would expect (considering the past year’s financial backdrop), the global “economic sphere” appears today in about the most robust position in some time. Yet, the “financial sphere” – with the leveraged speculating community having assumed the key source of liquidity creation – again faces dynamics that challenge its stability. In this regard, a couple of points are worth making. First, it should come as no surprise that the “financial sphere” is faltering. There is a fundamental flaw in the strategy of using “reflation” to rejuvenate faltering Credit and speculative Bubbles – inciting only greater speculative leveraging and fragility. What’s the endgame? Second, whether the Fed appreciates it or not, this “game” has now become immeasurable more difficult. The Fed (and the complicit Asian central banks) got the whole leveraged community – having mushroomed through the years with compound growth rates – all lathered up and all aggressively playing the same “reflation trade” – at 1% Fed funds. As to the scope of the global reflation, it has been a case of pretty much betting the ranch.
In past periods of heightened systemic stress, the Fed has always had the option of cutting rates and disseminating complimentary gains to the financial sector and speculator community. Such an option is not today available to mitigate worsening systemic stress. When the technology Bubble burst and financial wealth was being destroyed by the equity bear market, the Fed had the powerful capacity to offset these losses with the liquidity and wealth effects of surging bond and Credit instrument prices. Going forward, it is much more likely that equity losses will be compounded by rising yields and declining credit market wealth.
In this regard, I have always believed that the proliferation of hedge funds and proprietary trading, ballooning derivative positions and trading, and even the mushrooming GSEs – for that matter – have all been a bull Credit market phenomena. And while such a sophisticate financial scheme has many thinking New Paradigm, the reality of the situation is that they are all products of the Great Credit Bubble. Everything works swimmingly – that is as long as all the major players balloon together: the leveraged speculators, the derivative players, and the GSEs. And – fostering powerful expansion dynamics – the New Age Finance has had all the characteristics of something miraculous. Behind the curtain, the Fed had firm control of the pump, inflating the Bubble with each well-timed and choreographed reduction in interest rates.
But we are now commencing what will surely be an arduous Credit system bear market. Rates are spiking higher and the leveraged players and derivative traders feeling the heat. Hundreds of billions have flowed into the speculating community with inflated return expectations and minimal appreciation of the risks involved (especially systemic risks). Massive proprietary trading strategies have been implemented with the dangerous risk profile of “heads I win; tails you lose.” What’s more, the speculators’ traditional liquidity backstop/“buyers of first and last resort” – the GSEs – are in a pickle and not likely in a position to aggressively balloon their holdings. Meanwhile, the real economy is booming with an enormous supply of new mortgages as far as the eye can see.
From my perspective, it has always been only a matter of time until the Bubble realities of a massive supply of new Credit (required to sustain both inflated assets prices and maintain an unbalanced Bubble economy) and faltering demand for these Credits (rising rates, de-leveraging and derivative dynamic-hedging) led to problematic dislocation. For years, the demand part of this equation was artificially inflated by an historic speculative Bubble. We are now on course for potentially radically altered supply and demand dynamics. And this is truly the worst-case-scenario – with a booming consumption/asset-Bubble U.S. economy, 1% Fed funds, and synchronized global markets.
Over the coming days and weeks, we will monitor the situation carefully, with a keen eye on our Credit system and domestic Credit systems around the world. I hesitate at this point to conclude that a 97-style financial domino collapse is in process. My sense is that current tumult is much more associated with the unwinding of trades by the leveraged speculating community. This is in contrast to previous dislocations, currency collapses, mass capital flight, and consequent Credit system implosions that left domestic institutions, financial systems and economies starved of liquidity and then quickly insolvent. This looks different to me. And while interest rates are surging, I don’t yet see the characteristics of a global liquidity crisis. I sense that domestic Credit systems remain for now generally robust – or at least less vulnerable than previously - and capable of dispensing adequate Credit and liquidity, this despite the tumult in the capital markets.
Moreover, I do not at this point expect a major reversal in sentiment that would see a return to King Dollar speculative flows into dollar financial assets. Yes, the dollar is today gaining some lost ground as various bets are unwound. But this is a much different dynamic than the previous flight to play (Fed-induced) inflating U.S. financial asset prices. The prospects for enduring U.S. asset inflation are, these days, especially poor. Yet until our Credit system eventually buckles, unrelenting government and mortgage finance excess may very well finance ongoing massive current account deficits. This will work to support global system liquidity – offsetting liquidity lost with deleveraging. And while rates have risen meaningfully, they are not at this point sufficiently onerous to significantly restrain the U.S. mortgage finance Bubble or Asian growth. But it is reasonable to presume that these two respective historic Bubbles are in the process of experiencing their best days.
More from Greenspan: “We have, I believe, a reasonably good understanding of why Americans have been able to reach farther into global markets, incur significant increases in debt, and yet fail to produce the disruptions so often observed as a consequence…Can market forces incrementally defuse a buildup in a nation’s current account deficit and net external debt before a crisis more abruptly does so? The answer seems to lie with the degree of market flexibility. In a world economy that is sufficiently flexible, as debt projections rise, product and equity prices, interest rates, and exchange rates presumably would change to reestablish global balance…” “Fortunately, our meager domestic savings, and those attracted from abroad, are being very effectively invested in domestic capital assets. The efficiency of our capital stock thus has been an important offset to what, by any standard, has been an exceptionally low domestic saving rate in the United States.”
History will not be kind. As The Great Credit Bubble succumbs, our central bank will have to face up to the harsh reality that we have not saved or invested wisely – quite the contrary (“efficiency of our capital stock”? Give me a break). And absolutely no degree of “market flexibility” will mitigate our financial and economic misdeeds. There will be no painless defusing of U.S. imbalances. There has been no repeal of the Law of Economics. Finance is finance is finance.
And to add insult to injury, as a society, we face adversity with the prospect of having little in the way of even moral support from sympathetic friends around the world. And to think that we now approach an arduous financial and economic environment – with an increasingly hostile, uncertain and problematic global backdrop – leaves an especially bad taste in my mouth. I hope future historians will grasp the essence of what went astray and comprehend that there were poor decisions made all along the way. It didn’t have to happen this way. It shouldn’t have.
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