A True Paradigm Shift
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Credit Bubble Bulletin
by Doug Noland
October 24, 2003
<<...The captivating issue of “money supply” has recently been garnering more than its usual amount of attention and commentary. I’ll throw in my two cents worth. First of all, we must constantly remind ourselves that the contemporary financial system is a much different animal than conventional thinking gives it credit for. Traditionally, the financial system was essentially the banking system. This is simply no longer the case, as the banks share center stage with the Wall Street financial conglomerates, the GSEs, and securities markets generally. Importantly, contemporary “money” is anything but limited to government issued currency and bank created deposits. Moreover, the banking system no longer dominates the issuance of monetary liabilities (depositor assets) or commands the payment system. We have today the powerful money market fund complex, as well as instruments such as repurchase agreements and Eurodollars. Traditional money – currency and bank deposits – no longer exclusively represents “liquidity,” and a strong argument can be made that non-bank Credit creation (liability expansion by the GSEs, Wall Street, and foreign monetary authorities) is the driving force behind contemporary financial market-based “liquidity.”
Today, it is the nature of financial sector liability expansion that we must carefully monitor to garner clues for important systemic liquidity developments. There has been a recent notable stagnation of money supply after several months of heady growth. During the past 12 weeks, M3 has declined $37 billion, or 1.9% annualized. This is a dramatic reversal from the preceding 12-week period (weeks of April 28 to July 21) when M3 surged $220 billion, or 11% annualized. Digging into monetary component detail, we see that over the past 12 weeks Money Fund Deposits have declined almost $78 billion (Retail Money Fund deposits down $35.5 billion and Institutional Money Fund deposits down $37.3 billion), or 15.4% annualized. Meantime, Savings Deposits expanded $70.6 billion, or almost 10% annualized, with y-o-y year expansion of $466 billion (17%). Recent money supply stagnation is essentially explained by the decline in Money Market Fund deposits.
Clearly, there has been a tremendous flight to risk assets this year (out of the money market funds), but that doesn’t help much in explaining the dramatic monetary boom turned recent stagnation. There is also the issue of the collapse of the Refi boom that has played a role in the composition and holders of financial sector liabilities over the past several months. But talk of a collapse in net mortgage lending is poor analysis. Yet I do believe we can look directly to the recently mushrooming Fannie and Freddie balance sheets. They provide the best explanation for the abrupt stagnation of “money,” especially Money Fund deposits.
The GSEs have aggressively ballooned their holdings (mainly buying mortgages and mortgage-backs), providing liquidity to the banks, hedge funds, and Wall Street community. And, importantly, to finance this extraordinary balance sheet expansion, the GSEs have been issuing non-monetary IOUs/liabilities – long-term agency bonds (that are not a component of the “money supply”). Thus, we must appreciate that agency debt (as opposed to bank or money fund liabilities) has been over the past few months a predominant financial sector liability created in the unrelenting financial sector expansion (liquidity creation). The system has experienced tremendous liquidity creation resulting in little expansion of money supply components. This is a very atypical development in quite unusual times.
So I would tend to have my own view of the current liquidity situation: I believe the recent money supply stagnation is NOT indicative of generally faltering systemic liquidity. Indeed, it could be just the opposite. There is today a strange paradox of GSE induced over-liquefication financed by the issuance of agency bonds. Large quantities of these agency securities are being purchased by foreign central banks and international players recycling the raging surplus of global dollar balances. The Overriding Issue Remains Unrelenting Dollar Liquidity Excesses – an out of control Bubble of dollar financial claims creation. (At the same time, the grossly speculative and inflated U.S. stock market is a liquidity-Bubble accident in the making.)
This acute dollar over-liquidity view may be counterintuitive and even controversial, but there is certainly ample supporting evidence. I can point to continued over-liquefied Credit markets. Credit spreads domestically and internationally remain extraordinarily narrow (they’ve collapsed!), and demand for dollar denominated global risk assets (debt instruments in particular) remains unprecedented. Credit Availability could seemingly not be easier at home or abroad. The case for abundant dollar liquidity is also supported by surging gold and commodity prices, as well as a dollar that just cannot find its footing. Moreover, that “commodity” currencies -- the Australian dollar (up 25%), South African rand (up 24%), Brazil real (up 23%), Canadian dollar (up 20%), and Argentine peso (up 18%) -- are the leading global currencies this year lends especially strong support to my dollar over-liquidity/global reflation thesis.
It has been fascinating to witness truly historic financial evolution over the past decade. I have often attempted to explain how the Fed, GSEs and Wall Street have evolved to the point of having mastered the art of liquefying the market-based U.S. Credit system – Liquidity on Demand in Grand Excess. The nexus of this unparalleled power lies in the capacity for virtually unlimited GSE liability creation – insatiable demand for (implicitly guaranteed) GSE debt that can be issued in gross excess with no impact on perceived creditworthiness or investor demand (the “moneyness” of GSE liabilities); the Fed’s capacity/audacity to peg short-term interest rates significantly below market rates; the explosion of aggressive leveraged speculation; and, of course, the dollar’s role as international reserve currency. These provided a confluence of powerful forces unlike anything experienced in monetary or financial history.
This monetary/liquidity mechanism gained deserved credibility from rectifying the tumultuous market episodes of 1994, 1998, 1999, 2001, and 2002 experiences. Over the past several months, this “mastery” has been absolutely flaunted. Credit, liquidity and speculative excesses were taken to a whole new level. Interest rates began to shoot higher in July. Quickly, the highly leveraged and speculation-rife bond and interest-rate derivative markets faltered in near dislocation. But from July through September, Fannie and Freddie expanded their mortgage portfolios by the unprecedented $160 billion (compared to the 2nd quarter’s $13.3 billion increase). Problem “resolved.”
It is worth briefly rehashing the dynamics of GSE “liquefication.” Today, the system is acutely vulnerable to rising interest rates. For one, we face unprecedented leveraged speculation that would be forced into problematic liquidation in the event of a significant and sustained rise in interest rates. Second, there is great systemic risk associated with asset Bubble dynamics (especially throughout mortgage finance) and exceptionally weak debt structures after years of poor and excessive lending (Minsky’s “Ponzi Finance”). Third, there is this incredible interest-rate derivatives monster that expands with each new day of Credit and speculative excess. The GSEs, speculators, and other financial operators have purchased derivative protection against rising rates. Sellers of unfathomable quantities of “insurance” must “dynamically hedge” their exposure in the event of rising rates -- they are forced to sell/short Treasuries, agencies and other debt instruments into a declining market to establish positions that would generate the required cash-flow to pay Fannie, Freddie and all the rest in the event of a sustained jump in rates.
It is simply difficult to comprehend how our Credit system could avoid dislocation (a liquidity crisis) in the event of sharply higher rates. Everyone knows as much. Yet there is apparently no cause for concern. The Fed, GSEs and Wall Street have mastered the art of manipulating market rates and liquidity. With the first serious episode of spiking rates/speculator liquidation/derivative-related selling, the GSEs immediately commence the ballooning of their balance sheets (buying mortgages and other debt instruments). This accomplishes several crucial things; I’ll touch quite briefly on a few. First, it provides the leveraged players a “Buyer of First and Last Resort,” thus emboldening the community and keeping them in the game (no liquidation allowed!). Second, by aggressively acquiring mortgage-backed securities, GSE operations mitigate the amount of (duration) hedging that would otherwise be required by holders of these securities in a rising rate environment. And, most importantly, by capping the interest-rate rise, GSE liquidity operations greatly allay the amount of systemic derivative selling that would be necessary if rates were to jump sharply. Or, stated differently, the JPMorgans and Citigroups of the world, with their huge and growing interest-rate derivative positions, can sleep soundly at night with the confidence that the Fed and GSEs enjoy the capacity to manipulate rates lower at their discretion. With this – a guarantee of continuous and liquid markets, along with “pegged” low rates – a flourishing interest rate derivative market becomes viable. The key Credit Bubble perpetrators - the expansive Fannie, Freddie and speculator community - are advanced the cheap insurance necessary to ensure continued rapid growth. It's like buying flood insurance in an environment where the insurance community can carefully control the amount of rainfall.
A truly amazing system has evolved over time. And, let there be no doubt, “The Community” has ably and repeatedly demonstrated its capacity to regulate the amount of “rainfall”/interest rates/liquidity. The Fed can peg short-term rates at 1% and orchestrate a steep yield curve; the GSEs can sit back with the capacity to create enormous liquidity on demand; the leverage speculators can bet with reckless abandon; the financial sector can expand without limitation; inexhaustible liquidity can fuel real estate and securities inflation and resulting economic expansion; and the interest-rate derivative players can write unbounded policies with confidence that rates will simply not be allowed to shoot higher. All the while, the Credit system can expand aggressively with little concern for the endless supply of new dollar financial claims created. A Trillion here and a Trillion there, and there’s no downside. Speculative demand for securities will meet the ballooning supply, with little if any impact on the “controlled” interest rate markets. Cheap and plentiful Liquidity on Demand Forever!! A truly historic “achievement.”
This manipulation has an enviable track record, working so splendidly so many times. But there is a flaw and this failing is and will remain the focal point of my analysis. And this serious flaw goes right to the heart of A True Paradigm Shift. Yes, U.S. interest rates are today controllable and this reality does wonders for the entire fragile financial system and hopelessly distorted U.S. economy. And domestic demand for the endless supply of new Credit – inflated dollar financial claims - can be orchestrated by an expanding U.S. financial sector. But the flaw? Its Wildness Lies in Wait out there in the increasingly distrustful and less compliant global financial arena. The Almighty Fed, the Commanding GSEs and A Powerful Wall Street are today simply not well endowed when it comes to the capacity to manipulate global demand for Bubble Dollar Balances.
The bottom line is that, despite its repeated “successes,” this New Age Financial Control Mechanism (“The Great Experiment”) has not really been tested. Contemporary U.S. interest-rate/liquidity manipulation basically evolved over the King Dollar period 1995 through early 2002. The confluence of inflating U.S. asset prices, an outperforming economy, international high regard for the U.S. generally, and the impaired global financial system, worked to effortlessly recycle the rising flood of U.S. dollar balances right back to U.S. markets. There was absolutely no limit – no domestic or global constraints – on the amount of Credit creation (dollar claims inflation) generated during these U.S. liquefications. The liquidity jubilantly found its way right back to U.S. assets: the late nineties direct investment boom; the technology and U.S. stock market mania; and the Treasury/agency/”structured finance” securities Bubble. The ease of “recycling” dollar balances – of which everyone has grown so accustomed - was a most seductive aberration.
There are a few dynamics worth pondering. First, with the demise of King Dollar comes significantly reduced private demand for U.S. real and financial assets. Nowadays, relative performance of Non-dollar assets gains by the week, exacerbating Non-dollar financial flows. Second, Credit Bubble dynamics dictate (and recent GSE balance sheet ballooning provides evidence) that Credit excess (dollar financial claims inflation) must expand at an accelerating pace to support both levitated U.S. asset prices (real and financial) and an increasingly distorted Bubble economy. Thus, the dynamic of ebbing global demand and the accelerating flow of dollar claims pose a not inconspicuous dilemma. Importantly, however, global central banks have for the past year filled the void. This is not sustainable, and it is worth noting that dollar demand has been supported during this period by strong financial markets and a strengthening economy. Things can easily get much worse, and I would warn that there is a major problem with the markets complacency regarding the risk associated with dollar weakness.
I will return to the fascinating issue of mushrooming derivative positions and systemic risk. In the above discussion regarding interest rate risk, I made the point that derivative players - writers of interest rate protection - operate with the comfort that the Fed, GSEs and Wall Street command control over interest rates. And while it would be absolutely impossible for the $100 Trillion-plus interest-rate market to function as advertised, Financial Armageddon is apparently forever held at by the New Age U.S. financial system’s capacity to manipulate interest rates/liquidity.
The Big Flaw in Market Perceptions, however, is that similar manipulative dynamics operate with regard to dollar risk -- that a currency derivative crisis can be similarly averted. It is my view that such a currency crisis is today unavoidable. The New Age American financial system does today retain the incredible power to manipulate domestic interest rates through the inflation of additional Credit. Global currency markets are a different story. No matter what egregious quantity of U.S. Credit excess or financial sector leveraging, potential disaster can seemingly be resolved by low rates and only greater excess. The unfathomable mountain of interest rate derivatives have, through the wonders of financial manipulation, become a financial disaster scenario Moot Point. But these very same dynamics are nurturing runaway dollar claims/Credit inflation, and virtually assure incessant dollar devaluation going forward. I believe global markets – currency, gold, general commodities – are beginning to sense as much.
Over the past decade the dysfunctional global financial system has experienced repeated currency collapses. And from Mexico, to the SE Asian dominoes, to Russia, Turkey, Brazil and the spectacular Argentine meltdown, derivatives have played an instrumental role in all currency dislocations. Over and over we witnessed how a confluence of developments -- domestic financial excess, resulting booming economies, and exaggerated speculative flows -- all worked to nurture ballooning markets for insurance protection against faltering local currencies. Moreover, market dynamics generally dictate that in the manic late stages of the boom -- when Credit excess and foreign speculative flows go to extremes -- currency derivative positions mushroom. Demand for protection surges, while the escalating price of this insurance coupled with a speculative mindset entices (thinly capitalized) financial operators to write currency derivative contracts. In many instances, as was certainly the case in Russia and Argentina, the readily available currency insurance plays an instrumental role in prolonging Credit and speculative excess. Disaster is assured.
When the unavoidable run on the currency finally arrives (and, especially in the case of Argentina, it does often take longer than one would expect) there is absolutely no marketplace liquidity available for the writers of currency protection. Derivative players are simply unable to hedge their exposure. As dynamic hedgers, their computer models dictated heavy selling into declining markets. Such a scenario quickly elicits crowds of sellers and a buyers' strike. Markets dislocate and collapse.
Granted, the U.S. does not today have a vulnerable currency peg. I would argue, however, that unprecedented foreign central bank dollar purchases have to this point played the pivotal role in stemming currency dislocation. But these extreme measures have only bought some time. Importantly, U.S. domestic interest-rate/liquidity manipulation ensures an unrelenting flood of new dollar balances to be accumulated by our foreign Creditors. This is growing exposure that they would surely prefer to hedge against. Meanwhile, the Great U.S. Credit Bubble dictates that gross excess goes to only more unimaginable extremes. And all of this guarantees that the ballooning mountain of dollar derivative positions becomes only more intractable. All the Fed, GSEs and Wall Street can do at this point is make things worse. And are they ever doing it.
Any other Credit system would impose higher interest rates to help support their faltering currency. Higher market rates would work to quell financial excess and Credit inflation, the forces of currency devaluation. The Big Flaw in our New Age system of manipulated interest rates/liquidity creation is that we have mindlessly sacrificed the capacity to rein in Credit and liquidity excess. We simply can’t turn down dollar devaluation and have no intention of doing so. “It’s our currency, your problem.” The Fed and market players apparently believe that the dollar will calmly find some level commensurate with "fair value." But low rates and Credit Bubble dynamics dictate dollar devaluation as far as the eye can see. Such dynamics simply beckon for an eventual run on the dollar. And such a scenario would quickly overwhelm global central bankers already with massive dollar holdings they don’t know what to do with. I believe acute dollar vulnerability is here for the duration: A True Paradigm Shift in Global Finance, and certainly not one for the faint of heart...>>
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