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With the unprecedented degree of leverage throughout the economy and financial sector; out of control leveraged speculation; and an unfathomable interest rate derivative situation, we should not be surprised that the Fed is fixated on interest rates. But it is, nonetheless, amazing to watch the Fed and bond market so eagerly play into the hands of the dangerous mortgage finance Bubble. California and East Coast housing markets inflating at a pace near 20%, with Fed funds at 1% and variable mortgage rates at less than 3.8%? The Fed wants long-term rates lower and the Fed is now in a habit of getting even more than it wants. Fundamentals will have to step aside, for now.
Others have used the phrase, "The muddle through economy." I am not a big fan of this type of analysis, as it strikes me as the ultimate aggregation. Booming housing, "services" and government sectors -- offset by a moribund manufacturing sector -- today "balance" out at around 3 to 4% GDP growth. Yet it remains "muddle through" only as long as the Fed can perpetuate the Credit Bubble that sustains housing, "services" and government expansion. It is determined to do so, but the unavoidable consequence is only more intractable financial fragility.
I much prefer the notion of a "Dynamically Hedged Economy." A truly enormous leveraged speculating community and derivative juggernaut have evolved to dominate the financial markets and Bubble economy: The Powerful Force. As long as it is financially beneficial for this Powerful Force to expand, then liquidity and Credit availability are easily available. Financial and real assets inflate and (unsound) economic expansion follows. Serious problems, however, develop at any point where The Powerful Force becomes less expansive. Meanwhile, the larger and more leveraged they become, the more arduous the task of expanding and the more vulnerable The Powerful Force becomes to market volatility.
Last year, it became financially disadvantageous to own corporate bonds - in many cases it was actually quite profitable to short them. The leveraged speculating community was liquidating positions and shorting, fostering a Credit availability disappearing act. Liquidity was evaporating throughout the corporate market, and the dominoes were beginning to fall. Derivative players on the wrong side of a faltering corporate bond market were forced to dynamically hedge their exposure; they were forced to sell bonds that were in decline, causing heightened (self-feeding) market turmoil. The Dynamically Hedged Economy was on the brink. It was the exact opposite of today's Credit environment: as night is to day.
To understand today's environment it is important to appreciate that the Fed looked at potential debt collapse last year and said, "We'll have absolutely none of that!" Team Bernanke/Greenspan aggressively cut rates and signaled to the market that they were willing to flood the system with liquidity to resolve the dislocation (couched in terms of fighting "deflation" - much more palatable than fearing "debt collapse"). The rest is history. The leveraged speculators and derivative players began to reverse their short positions, setting in motion a self-reinforcing return of liquidity and Credit availability (not to mention one heck of a speculative stock market run). Not only did the derivative players reverse bearish bets, The Powerful Force began aggressively taking leveraged long positions. It was one of history's most precipitous Busts to Booms.
A few weeks ago hedge fund manager extraordinaire Leon Cooperman was on "Kudlie and Cramie." His fund is up big this year, and Mr. Cooperman was pleased to explain his very successful bet on the junk bond market. "The government wanted us to own them," if I recall his comment accurately. There was also a story this week of a large hedge fund that has a 20% plus y-t-d return, largely on a successful big bet on Conseco Credit default swaps. Conseco bonds and other distressed securities benefited tremendously from the Fed's aggressive reliquefication. The Fed wanted the speculators to buy. Success stories are easy to find these days throughout the leveraged speculating community. Everyone is fat, happy and complacent.
The point being, the Fed has (for too long) been playing to a very captive and expanding audience. And not only has The Powerful Force mushroomed tremendously over the past few years, financial innovation has created only more efficient ways to place leveraged bets. As dire as things looked last fall, the Fed still retained the capacity to call out The Big Guns and entice the leveraged speculators and derivative players to cover short positions and go aggressively long. They did.
There are now extraordinary dynamics at play that make today's environment absolutely fascinating. For one, there is a strong inflationary bias throughout the global Credit system, with overabundant liquidity available for about any individual, company, government entity or country. Our policymakers have made it perfectly clear - to the home owner, to the stock jockey, to the global bond players, to the derivatives trader - that leverage is the way to easy profits. And Everyone has been rushing full-throttle to play inflating asset markets. It is a truly amazing thing to witness. That it has come to seem so normal makes things all the more riveting. To see Everyone on the same side of the boat... The stock market boat has begun to rock.
Moreover, virtually no one voices concern about the speculative excess running roughshod throughout the stock, bond and emerging markets, as well as the California/national housing markets. The "good" news is that Everyone is keen to expand holdings (inflationary bias). The bad news is that these holdings are growing exponentially and their liquidation will be a big problem. There will be no one to take the other side of the trade.
For now, as is always the case during the halcyon days of expansion and financial excess, things look wonderful to virtually all. Finance is ultra-easy, financial profits and "wealth" creation are ultra-easy, and asset inflation is ultra-seductive. But don't Credit and speculative excess invariably sow the seeds of their own destruction. Yes they do, but it is today worth pondering that, traditionally, the Credit market begins tightening in anticipation of the Fed's less accommodative stance. Nowadays, with an unprecedented depth and breadth of financial excess, the Fed is screaming, "Don't Tighten Credit System!! Please Don't Tighten!" The Credit system is responding with a, "OK, fine by us."
So bond yields have declined sharply. This is forcing the speculators and derivative players that were short bonds to buy them back. Sinking yields, then, raise the possibility of a reemergence of a destabilizing refi boom (and at the minimum throw gas on the mortgage finance Bubble). Such a potentiality could easily unnerve the crowd of mortgage-back operators, where more hedging activities would only push bond yields lower. And, of course, many a speculator would want to jump on that train, fueling rising bond prices and collapsing yields. Is this any way to run a Credit system?
And what about the housing Bubble and forecasts for 5% second half growth? Aren't yields too low considering the demand for borrowings? Well, yes they are; but that's missing the point. The Fed has nurtured The Powerful Force and right now it wallows in the strong inflationary bias ingrained throughout the financial system and in sectors of the real economy. Perhaps bond yields are signaling an economic slowdown, but it appears more like they are being buffeted by financial instability. For now, it appears market dynamics rule and our housing markets and Dynamically Hedged Economy are along for the ride. This is a dangerous creature the Fed has reared and cut loose.
Things have really run amok. And that the consensus so confidently holds the view that things are going along absolutely swimmingly only increases our fear of a looming financial surprise. We, today, see many of the ingredients. And reiterating last week's point, the resurgent bond bull and hyper-resilient Credit Bubble are not good news for the dollar. That the stock market would all the sudden get shaky knees is interesting. Driven to major speculative excess on the back of a glut of liquidity and delusions of benevolent reflation, the stock market is now left to grapple with an exceedingly unruly financial environment. |
