noland is certainly on-topic this week with an explanation for the flattening yield curve. whenever it reverses, it is gonna cause some havoc
More from Mr. Otmar Issing
prudentbear.com
We are this week provided a few moments of central bank sanity from our old favorite ECB Chief Economist, Mr. Otmar Issing. I have excerpted from his short paper “Monetary Policy and Asset Prices,” available online at www.boersen-zeitung.com.
“Which role should asset prices play in the conduct of monetary policy? This question has gained more and more attention in recent years. However, the answers are anything but straightforward…”
“Prevention is the best way to minimize costs for society from a longer-term perspective. Central banks are confronted with this responsibility, but there is no easy answer to this challenge. So far, only some tentative conclusions can be drawn.”
“First, in their communication central banks should certainly avoid contributing to unsustainable collective euphoria and might even signal concerns about developments in the valuation of assets.”
“Second, the argument that monetary policy should consider a rather long horizon is strengthened by the need to take into account movements of asset prices.”
“Finally, it should not be overlooked that most exceptional increases in prices for stocks and real estate in history were accompanied by strong expansions of money and/or credit.”
“With stable prices money serves society best as a unit of account, medium of exchange, and store of value. Any index of consumer prices covers only a segment of prices in an economy – although an important one. Prices of assets like real estate or equities are excluded from the definition.”
“We have learned on many occasions that excess liquidity can show up in excessive asset valuations and not only in consumer price inflation. Sooner or later, then, unsustainable asset price trajectories may translate into sizeable risks to price stability -- in either direction -- and often much further down the road as the long-run fallout of the Japanese bubble of the late 1980s has shown.”
“To my mind the risks associated with asset price inflation and subsequent deflation are an important additional reason for paying close attention to money and credit, over and above the regular and well-established link between money and consumer prices.”
“Thus, a monetary policy strategy that monitors closely monetary and credit developments as potential driving forces for consumer price inflation in the medium and long run has an important positive side effect: it may contribute at the same time also to limiting the emergence of unsustainable developments in asset valuations. In other words: as long as money and credit remain broadly well-behaved the scope for financing unsustainable runs in asset prices should remain limited.”
“The tendency of modern textbooks on monetary theory and policy to relegate money and related concepts to inconsequential footnotes can be no comfort. What is the role of liquidity, financial frictions and the flow of funds for the real economy and the relation of money vis-à-vis a broader range of asset classes? While a full grasp of the interplay between the real economy and monetary and financial variables remains elusive, the asset price cycle playing out in the late 1990s and peaking in early 2000 has again forcefully brought to the front the importance of careful analysis of financing flows and balance sheets considerations, on the side of households, the corporate sector as well as the financial system.”
“The more the monetary and financial side of the economy is given its proper weight in the ongoing analysis of central banks and in their monetary policy deliberations and the more extended its policy horizon, the lesser will be the need to contemplate exceptional ‘escape clauses’ for the monetary policy strategy. At the same time, such a strategy offers a framework to face up to central banks’ responsibilities in this realm...”
It is refreshing to read central banking philosophy from the well-grounded ECB perspective. What a contrast to that espoused by the Greenspan Federal Reserve. The ECB recognizes the necessity for adopting a long-term focus, while the Fed’s realm is the short-term and zealous activism. Mr. Issing exhorts that “central banks should certainly avoid contributing to unsustainable collective euphoria.” Mr. Greenspan has over recent years become a proponent of “the New Economy,” derivatives, structured finance, and even the liquidity and “flexibility” benefits of an expansive hedge fund community. Indeed, the activist Fed specifically targeted leveraged speculation and mortgage borrowings as the key reflating mechanisms in the post-technology Bubble environment. With short-term expedients come long-term costs and uncertainties.
There is today – in The Intoxicating Global Liquidity Bubble World – little appreciation that Mr. Greenspan’s short-term activism is coming home to roost. Back in November he made a remarkable comment: “Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money.” If only the world’s marketable securities-based Credit systems and the massive global pool of speculative finance could be managed so easily. I would argue that the essence of Mr. Greenspan’s comments lies at the very heart of failed Fed policymaking - and attendant Monetary Disorder.
Ponder for a moment a scenario where, let’s say, the Fed had warned in 1999 that NASDAQ was poised to decline. Duly warned, investors, day-traders, Wall Street proprietary trading desks, hedge funds and others would surely have simply gone out and purchased put options and locked in bull market gains (choosing to buy insurance while playing the hot game for all it’s worth!). In theory, life in the markets would have been just swell.
But the reality of the situation was quite to the contrary. NASDAQ was in a powerful yet unsustainable Bubble. When the Bubble eventually burst, those that wrote NASDAQ derivative exposure were on the hook for major losses. And it is important to appreciate that those writing put options and other derivative protection are generally thinly capitalized financial institutions and speculators. Such players must rely on “dynamic trading” hedging strategies that entail selling/shorting, in this case, NASDAQ stocks and instruments to offset the “insurance” exposure that escalates when a market commences a major decline. And when a large portion of the (fully-invested) marketplace acquires put options to “lock in a bull market,” this assures massive “dynamic” selling into a declining market with few willing and able buyers. The inevitable outcome is a collapse in marketplace liquidity.
Yet, there is more to this basic NASDAQ/”market hedging” example that may offer some insight into the current peculiar bond market environment. Let’s say the Fed warned of the coming NASDAQ decline in mid-1999. And, over the following few months, participants aggressively shorted tech stocks and NDX futures, while loading up on puts. The writers/sellers of these derivatives would then partially hedge their exposure by shorting individual stocks and/or indices. Hedges and bearish bets, rational ones at that, would be put on in size.
End of cycle euphoria and Bubble dynamics would, virtually by definition, create ample liquidity to accommodate these sales. There would be, as well, critical dynamics in the “economics sphere” to match those in the “financial sphere.” Importantly, this same “blow-off” liquidity would tend to significantly distort (“inflate”) fundamental factors such as company/industry revenues, earnings, and cash flow. Arguably, bull markets and booms create their own liquidity and “positive” fundamentals. As such, contemporary finance demonstrates a proclivity to foster extraordinarily unstable marketplaces replete with, on the one hand, seemingly exceptional fundamentals and, on the other, rising short and derivative positions. Moreover, these bearish positions – as Bubble dynamics again make certain – reside in “weak hands.” The bloodied bears and the derivative players with shorts become open game in what becomes a wildly speculative marketplace. This is one aspect of the very unstable nature of financial Bubbles and why the ECB is correct in arguing that they must be dealt with long before they burst.
I strongly argue that such a scenario – the confluence of Bubble dynamics, central bank warnings, system-wide hedging, and acute “economic sphere” distortions – create the perfect backdrop for major market dislocation. And, in reality, the NASDAQ100 index did doubled from its elevated June 1999 level during the subsequent nine months. A historic short-squeeze and enormous derivative positions played instrumental roles in this spectacular market breakdown. And while an overt Fed warning was not a factor, the Fed was raising rates and was exhibiting increasing public concern. The existence of highly liquid markets for derivative protection clearly played an instrumental role in fostering boom and bust dynamics and acute financial fragility.
While some participants do effectively use derivatives to, it is impossible for a large portion of the market to successfully hedge against a major market move. I assert that the circumstance of major share of the marketplace hedging market exposure during the late-stage of Bubbles greatly increases the probability one of two scenarios: One, the market commences a downward spiral, overwhelmed by self-reinforcing “dynamic” derivative-related selling pressure. The second scenario – and I argue passionately that Bubble dynamics increase the likelihood of this outcome – is one of a final “classic” spectacular marketplace blow-off: the animated crowd recognizes that the game is nearing its end and puts in place its bearish bets and hedges, only to get run over by the final short-squeeze and buyer’s panic melt-up (including the throngs of attentive speculators buying in front of those caught short). Marketplace dynamics virtually assure that the crowd and their derivative counterparties will be forced to unwind hedges in the final dislocation. Not only does this lead to heightened marketplace volatility and indecision, it also exacerbates the widening chasm between current market prices and prospective economic values.
One other key aspect of the final short covering/derivative unwinds/speculator euphoria melee is not as obvious: This process creates massive liquidity that perpetuates and exacerbates the attendant boom in the industry/economy (“economic sphere”). The financial sphere will have over time expanded and evolved to over-finance the Bubble, while the most aggressive risk-takers (“proved right”) will have been elevated to top decision-making positions. Support from the political establishment also reaches full bloom. Importantly, this final destabilizing liquidity onslaught fosters the most egregious excesses throughout the real economy. These include misallocation of resources and – certainly as we saw throughout the tech/telecom sectors – over and mal-investment that ensures the collapse of industry profits as soon as the unsustainable liquidity bulge runs its course.
This brings us to the current environment. Despite Mr. Greenspan’s warnings and six Fed rate increases, the U.S. Credit system’s liquidity bulge has at this point anything but run its course. The homebuilding and consumption boom runs full steam ahead. Should we have expected anything less? It is my view that interest-rate markets succumbed to a marketplace dislocation not unlike NASDAQ in that fateful period second-half 1999 to early 2000. An enormous amount of interest-rate hedging was put in place that was, in reality, untenable. Again, I would assert that the Fed’s warnings of higher rates and the market’s rational reaction (large-scale hedging and bearish speculating) assured either a self-reinforcing downward spiral in bond prices (spike in rates) or an unfolding major “squeeze,” derivative unwind and destabilizing drop in rates. We are witnessing the latter.
With nightmares of 1994 – and cognizant of today’s highly leveraged and fragile financial landscape - the Fed expressly erred on the “side of caution.” Ample warning, extraordinary “transparency,” and promised ultra-baby step (with pauses?) rate hikes were incorporated specifically to accommodate the leveraged players. At the same time, the financial sector was afforded ample time and opportunity to adjust its products and programs to assure uninterrupted boom-time Credit Availability and liquidity. The Mortgage Finance Super-industry, in particular, developed and aggressively marketed variable-rate products, interest-only loans, and flexible home equity lines of Credit. Wall Street investment bankers focused on issuing variable-rate corporate debt, while the “financial engineers” in structured financed set their sights on transforming $100s of billion of variable-rate and subprime mortgage loans into enticing collateralized debt obligations (CDOs), MBS, ABS, and myriad derivative products.
The Credit system hasn’t missed a beat, and that’s a problem. The ongoing liquidity onslaught throughout the U.S. and global Credit system, echoing NASDAQ 1999, has wreaked distortion havoc on both the “economic sphere” and the “financial sphere.” Conspicuously, over-consumption, massive Current Account Deficits and unprecedented central bank dollar security purchases have taken center stage. The greater U.S. lending and spending excesses, the greater the force of foreign central bank recycling operations back to the Treasury and agency markets. And talk of a paradigm shift to permanently low market rates (all too reminiscent of “blow-off” notions of enduring tech multiples) grows louder. Bubble distortions – foremost liquidity excess - under the façade of amazing fundamentals have played a major role in inciting a short-squeeze and unwind of interest-rate hedges throughout the Credit market.
And while on the surface not as spectacular as the technology stock melt-up, we do have the homebuilders. Further evidence of blow-off excess can be found in paltry corporate, junk, ABS, and MBS spreads. Credit default swap prices have sunk as well. Globally, emerging bond spreads are extraordinarily narrow, while equity markets remain red hot. Basically, liquidity excess and multi-year low risk premiums have become the norm throughout global finance. The system is poised for another Trillion plus year of Mortgage Credit growth.
And no discussion of Bubble distortions and potential dislocation in the interest-rate markets would be complete without some mention of GSE balance sheets. Unfortunately, Fannie and Freddie haven’t issued financial statements in awhile. But looking at 2003 year-end statements, Fannie and Freddie had at the time combined short-term liabilities approaching $800 billion (total assets of about $1.8 Trillion). Let’s assume those numbers have stayed about the same, and then add an additional $200 billion or so for the FHLB. We can throw out a rough estimate of $1 Trillion of GSE short-term borrowings. As derivative kings, the GSEs have aggressively entered into interest-rate swap agreements and acquired other derivative “insurance” to hedge their mismatch between the expected life of their (generally) mortgage assets and the average duration of their borrowings.
We can only hope that the GSEs are more adept at derivative hedging than they are accounting. But one can look at the current yield curve environment and see plenty of potential for error. Let’s say the GSEs entered into swap agreements to hedge the risk associated with a Fed tightening cycle. In such a swap, they might choose to pay some fixed rate to receive whatever is the going 10-year Treasury yield. Historical models would forecast that 10-year yields would likely experience a greater increase in yields than the rise in Fed short-term rates (recall 1994) – models would expect 10-year yields to rise and the yield curve to steepen. This swap would be expected to hedge against the rising cost of their short term debt. But what would happen if the cost of financing the massive GSE short-term debt rose but 10-year Treasury yields actually dropped? And what would be the consequences if such hedges began to falter for the GSE and throughout the marketplace? Would players be forced to restructure their hedges – perhaps forced to buy the 10-year (on leverage, of course) and short the 2-year instead? And would the yield curve effects of such a move by huge market players force others to cover short positions and unwind hedges out the yield curve, while shorting, say, 2-year Treasuries? Am I suffering from a wild imagination when I ponder the possibility that such operations could be inciting destabilizing yield curve gyrations and derivative hedging tumult?
Well, enough conjecture for this week. But a very fascinating dichotomy is developing in the marketplace. After beginning the year with a hiccup, global bond and equity markets have generally regained their strong momentum (U.S. equities are lagging). And we see this week continued price gains in the energy markets, as well as resurgent commodity markets. Furthermore, the “commodity currencies” were quite strong this week. While I appreciate that many are calling for the demise of the “reflation trade” – long commodities, commodity currencies, and emerging markets, while short the dollar – recent weakness may prove only a pause that refreshes. It is also worth noting that economists have begun to revise U.S. growth higher, and there are signs the global economy is demonstrating similar resiliency (not surprising considering the interest-rate and liquidity backdrop).
So if reflation retains its vigor; economies their resiliency; and the Global Liquidity Bubble its tenacity; what the devil is the 10-year Treasury yield doing at 4.09%? Has the recent drop in yields (and yield curve gyrations) been fundamentally or technically driven? Are we in the midst of the best of times for the bond market or, instead, an environment characterized by instability and dislocation? How exposed has the marketplace become to an abrupt reversal of fortunes? I suspect that short covering and the unwinding of derivative hedges is placing the marketplace in an increasingly vulnerable position. And it’s always these abrupt market “Vs” that cause the derivative players the most grief. As was the case with NASDAQ, one day derivative traders can be panic buyers only to have a market reversal hastily transform them into aggressive sellers.
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