I think you'll find Noland a good read this week. He sees the wizards losing control
prudentbear.com
Issues 2005
I have never met Stephen Roach, but I sure admire him. On Bloomberg television the other day he a simple commented that really resonated: “…It’s important, number one, just to go back and really do a personal inventory of how your view, how your lens, how your prism worked.” Over the years he has been an impressive role model characterized by independent thinking, humility, diligent analysis, and a disciplined approach to adopting and refining his analytical framework.
Yet to better understand from where we have come and to where we might be going, I do want to contrast his “prism” from my own Macro Credit (including Bubble and speculative finance dynamics) analytical framework. Extracting sentences from Mr. Roach’s latest article, he writes, “For me, many of last year’s lessons are interrelated — part and parcel of the general framework of global rebalancing that has guided my macro view over the past few years… Suffice it to say, the resolution of global imbalances has hardly had a major impact on share prices… I viewed the dollar’s renewed decline in late 2004 as an encouraging development on the road to rebalancing… Up until now, currency realignments have borne the brunt of global rebalancing.”
I share a great deal of common ground with Mr. Roach, but our distinct “prisms” lead us to some divergent views of what 2004 was all about. While I subscribe to the view that a major global rebalancing is as imperative as it is inevitable, I can find little evidence that this arduous process has commenced. I don’t see encouraging signs that the dollar’s three-year decline has yet to incite global rebalancing, and there certainly isn’t any “resolution” in the works. Global financial and economic imbalances have grown only more acute and unwieldy. But I do expect markets to (much belatedly) force the onset of this “rebalancing” process at some point during 2005.
The U.S. Credit system and asset markets are the focal point of my analysis. Only restraint in Credit creation and the termination of asset Bubbles will initiate the required “rebalancing” – domestic as well as global. Until asset and speculative Bubbles burst, the dysfunctional U.S. financial sector will maintain its dangerous fixation on asset-based lending and interest-rate arbitrage. At this point, only a crisis will force the curtailment of over-consumption and the misallocation of resources. And rather than viewing the dollar’s fall as an encouraging development, from a Credit Bubble perspective, it is exactly what one would expect to coincide with the “blow off” period of Credit and liquidity excess.
When I reflect back upon 2004 through my analytical framework, I see Reflation dangerously transformed into Gross Over-liquefication, on a global scale never before experienced. What do I mean by this? Ultra-accommodative Fed policies that reached a crescendo in late 2002 nurtured blow-off excesses throughout U.S. mortgage and securities finance – Bubble at The Core. This dynamic set in motion an all-encompassing liquidity free-for-all domestically and globally, creating Myriad Bubbles all along The Periphery. From subprime, junk bonds and virtually all securities; to hedge funds, REITs and M&A; to energy, commodities and essentially all hard assets; to emerging debt and equity markets, cheap finance was abundant in virtually every nook and cranny across the globe.
I believe this is very pertinent analysis with respect to contemplating where and how we proceed from 2004. While some may view the weaker dollar and stronger global growth as factors reducing systemic imbalances and risk, I fear the exact opposite: An historic Bubble has gone to only more dangerous and endemic extremes. Indeed, Macro Credit/Bubble analysis leads me to place the potential for financial crisis at the very top of Issues 2005. Last year it was incumbent upon the Fed to demonstrate resolve by tightening financial conditions and repressing burgeoning excess – retraining reflation from its proclivity to run out of control. Once again, the Fed has erred on the side of upholding excess, which reinforced already strong inflationary biases throughout the U.S. and global securities markets. Systems have become only more dependent on abundant Credit and liquidity.
There are many that view easy Credit and teeming liquidity as part and parcel to the New Paradigm, engendered by contemporary finance coupled with a technology-induced productivity revolution. And there is these days more talk of a secular decline in financial market volatility. Such a view has been emboldened by 2004’s collapse in Credit and risk spreads, as well as the bond market’s (and general financial markets’) resiliency in the face of a sinking dollar. This is a hook – an analytical trap.
From my analytical perspective, the notion of a secular decline in financial volatility is the ultimate in Analytical Irrational Exuberance. It is “secular” only so long as Credit Bubble and liquidity excesses are sustained; as long as inflated asset prices continue inflating. Indeed, the collapse in risk spreads is one critical manifestation of Gross Systemic Over-Liquefication. And this liquidity emanates directly from profligate lending throughout mortgage finance, unprecedented securities leveraging, and unparalleled expansion of central bank holdings of U.S. securities. Indeed, The Great Analytical Paradox of 2004 was the collapse in risk premiums concurrent with heightened Monetary Disorder. This aberration is not sustainable.
Importantly, I would strongly argue that Credit Market Dislocation was The Untold Story of 2004. Clearly, the massive dollar-denominated securities purchases by foreign central banks distorted bond prices and general marketplace liquidity. And with the U.S. current account destined to be even larger during 2005, it is reasonable to presume another year of enormous central bank buying and continued low bond yields. I would be very cautious with such extrapolations.
There are important but ambiguous facets to last year’s dislocation. To what extent did massive and unending foreign central bank purchases distort the marketplace? Somewhat more specifically, to what degree did these operations entice the leveraged players to maintain or, even, sharply increase their speculations? I would strongly argue that with the Fed raising rates, with oil and commodity prices spiking, and general consumer inflation on the rise, the speculators would have typically been defensively reducing leverage rather than offensively increasing it. On the margin, this had a profound impact on marketplace liquidity and interest rates. Moreover, with both central banks and speculators increasing positions, the resulting decline in yields caught the bears, those hedged, and the derivative players all on the wrong side of the market. The resulting unwind and related leveraging – an important facet of the Monetary Disorder created by Credit excess, the falling dollar, and massive global central bank support operations – was a powerful force behind collapsing spreads, system Over-Liquefication, heightened asset inflation, and self-reinforcing Credit and liquidity creation.
A year ago the marketplace and general financial backdrop appeared conducive to a period of surprisingly low interest rates. Many had positioned for a jump in yields (and ended up paying for their caution). Today, I see much the opposite. Market perceptions have ongoing global central bank purchases sustaining low market rates and profuse liquidity for as far as the eye can see. Some even see the Fed as having almost completed their “tightening.” Last year’s worry is gone, which is reflected in the depressed price of interest rate derivative protection (and risk premiums generally). The fundamental backdrop is one of notably easier financial conditions and heightened inflationary pressures than 12 months ago. It will be fascinating to watch players talk low rates and weak economy as they work to reduce their bond exposure.
Pondering the current economic and financial landscape, I sense an unusually high probability that the leveraged speculators and hedgers/derivative players will again prove this year’s price setters – but for 2005 as sellers instead of buyers. The risk of an upward surprise in inflationary pressures, a resilient Mortgage Finance Bubble “blow-off,” and a global backdrop of aroused animal spirits and rampant liquidity -- the possibility of the Fed having to move aggressively to avoid falling even further behind the curve is anything but remote. And with the extreme amount of leveraging and the potential for massive derivative hedging-related selling (trend-following “dynamic” trading), the possibility for a major and abrupt spike in market rates should not be dismissed.
We certainly begin 2005 with many of the necessary conditions for a surprising spike in yields that could easily lead to marketplace dislocation. Perceptions are bullish and complacent, while last year’s dislocation induced many to remove hedges and many dynamic hedgers to be positioned leveraged on the long side (by ready to sell when rates move higher). And as much as 2003 recalled the bond market mania of 1993, 2004 brought back memories of the SE Asia/emerging market excesses of 1996. By promising little bitty Baby Steps (“Tightening Lite”) that would never ever dishearten the precious markets, the Fed last year avoided a 1994-style interest rate speculator boom turned bust. But the cost of sustaining the U.S. Credit Bubble was inflating myriad Bubbles around the globe. Not only does this increase global risk to a bursting of U.S. Bubbles, it also creates a risk that faltering Bubbles anywhere at The Periphery could now spark speculator losses, risk aversion, de-leveraging and contagion effects that could easily jeopardize The Vulnerable Core (recall the trail of Thailand to all of SE Asia to Russia to LTCM to the U.S. Credit market “seizing up”).
From my “prism,” I cannot overstate the degree that 2004’s Monetary Disorder translated into liquidity excess and Bubble dynamics taking hold at The Periphery. These Bubbles include subprime mortgage, home equity lending, the REITS, Credit default swaps, junk bonds, and “emerging” debt and equity markets, to name only a few. The nature of excess and Bubbles at The Periphery is that they are always sensitive and vulnerable to developments at The Core. And one can think in terms of Reflation having degenerated into problematic Gross Over-liquefication at the point when liquidity and speculative excess inundated The Periphery. This 2004 development sets the stage for Trouble at the Periphery during 2005.
And there is also the issue of the hedge fund community. Last year marked another huge year of inflows to the leveraged speculators. This was despite lacklustre performance that was made respectable by the big year-end rally in U.S. and global markets. Never had so many managing so much wanted so badly to have markets rally into year end. Well, what do you know… And it is an interesting facet of Speculative Dynamics that a popular investment theme or asset class receives keenest attention – and largest financial flows! – after returns have peaked and often when they are declining rapidly. This year certainly holds significant potential for disappointing performance and a reversal of flows to the leveraged speculating community. At the minimum, crowds of anxious (and leveraged) hedge fund managers chasing limited opportunities are not conducive to stable markets. This is an Issue for 2005.
Macro Credit and Bubble analyses are as fascinating as they are challenging. As much as we analyze and gain understanding from studying the intricacies of Bubbles, there should be an axiom that warns to absolutely avoid predicting when they are going to burst. What’s more, the bigger and more conspicuous the Bubble – the more confident we are in our analysis - the more likely that forecasts of its demise will prove as much as years premature. This was the case with the NASDAQ Bubble and now with the Mortgage Finance, Leveraged Speculation, and U.S. bond market Bubbles. Excesses go to unbelievable extremes – and then “double.” Almost by definition, those of us that partake in Bubble analysis will, from the consensus’s point of view, be discredited and our analysis in disrepute at the pinnacle of the Bubble; it just goes with the territory. A sound analytical framework, along with perseverance, becomes an absolute prerequisite.
With that caveat out of the way, I believe there is a reasonably high (much greater than 2004) probability that we will experience a major Bubble burst during 2005. The nature of current blow-off excesses will not run indefinitely, and Inflationary Manifestations will only turn more destabilizing. As we appreciate, it is the very nature of Credit, asset and economic Bubbles that they are sustained only by greater amounts of Credit. Contemporary finance, these days dominated by marketable securities, leveraging, and speculation, is hooked on cheap, abundant liquidity. And we have reached a stage in the cycle where heightened and broadening inflationary pressures dictate that a continuation of Credit Bubble excess will manifest into traditional consumer inflationary pressures. The stability of the $3.2 Trillion “repo” market is a major Issue for 2005.
The U.S. economy is in the midst of a distorted boom, with an increasingly ingrained inflationary bias. Asset Bubbles are heavily influencing spending and investing patterns, hence the underlying structure of the economy. The nature of the U.S. Bubble economy – where gross financial excess is required to fuel minimally acceptable employment gains – will be an Issue for 2005. Current market rates and liquidity conditions appear poised to initially foster stronger-than-expected demand domestically and globally, although the unstable and unbalanced nature of the current global expansion will continue to provide fodder for those arguing for an imminent slowdown. I expect the Chinese and Asian inflationary booms to become increasingly problematic. Energy and commodities will remain in tight supply, with prices extraordinarily volatile but with a continued upward bias. The current minority Fed view that inflation and marketplace speculation pose increasing risks has potential to become consensus. And I can certainly envisage a scenario of increasingly anxious central bankers eyeing inflationary pressures and unstable markets across the globe.
I wrote last week that 2004 was “The Year It Didn’t Matter.” The markets were content to disregard accounting irregularities and capital inadequacy at the GSE in the bountiful liquidity environment of 2004. There will, however, come a time when the GSE’s role as Buyers of First and Last Resort for the Leveraged Speculators will be a major issue. When interest rates spike higher and the marketplace falters toward dislocation, the degree to which the GSEs can balloon their balance sheets will be of immediate critical importance. If, as one would today presume, the GSEs have lost their capacity for unlimited balance sheet expansion, this could prove a major Issue for 2005. And I have in the past argued that the GSE’s capacity to “reliquefy” the Credit market has repeatedly been a critical factor in containing interest rate spikes/dislocations.
For some time there has been circularity at work. The highly leveraged and exposed GSEs were, on the one hand, major buyers of derivative protection against higher rates. One the other hand, their aggressive balance sheet expansion at critical junctures ensured that the writers of this “insurance” would not be exposed to loss. The GSE played a vital role in the viability, hence the explosion, of the interest-rate derivatives marketplace. If the GSE’s have lost their quasi-central bank status, there are momentous ramifications that will become inopportunely relevant during the next unfolding liquidity/financial crisis.
There is a much riding on the continuation of Credit and liquidity excess. The Great Credit Bubble has spawned a long and lengthening list of Bubbles. The Bubble of leveraged interest rate speculation and the closely related Mortgage Finance Bubble are historic. And the sibling California real estate mania, along with Bubbles in scores of housing markets along the coasts and across the country, has inflated to quite dangerous extremes. The California Housing Mania, in particular, is vulnerable to any significant increase in adjustable mortgage rates. I will go out on a limb with the view that the vulnerable California market is in the process of topping and will be in trouble by year end. Other overheated markets will follow the Golden State, and evidence of the massive amount of mortgage-related fraud that has transpired - as the Fed has nurtured and watched this Bubble unfold - will begin to surface.
And while the dollar is currently mustering its strongest rally in some time, I do not expect 2005 to be any kinder or gentler to our currency. The very serious issues of bursting Bubbles and financial system integrity remain to be resolved. In the meantime, there will be another year of massive current account deficits and, quite likely, a continuation of speculative flows to commodities and non-dollar assets and markets that will weigh on our currency. I have been surprised that the dollar has been incapable of mounting even a respectable bear market rally – especially considering the amount of currency speculation and derivative hedging that would be expected to make for some dramatic price swings.
From my analytical vantage point, 2005 appears poised for only greater Monetary Disorder. And I do sense in the marketplace an unusually high degree of uncertainty and indecision. This is as one would expect considering the confluence of over-liquidity, gross speculative excess, and acutely fragile Bubble underpinnings. Uncertainty and indecision would appear to guarantee wild volatility and unpredictability in various markets. Indeed, I expect increasingly treacherous market conditions as the year progresses. Cash is anything but trash, and currently inflated prices and depressed risk premiums across virtually all asset classes create a very unfavourable risk vs. return outlook for most markets. I expect the confluence of the Chinese/Asian/emerging market booms and uncontrollable dollar liquidity excess to support energy and commodity prices. The flight out of dollar balances into perceived better stores of value is in its infancy.
The Critical Issue for 2005 is the commanding role speculative leveraging has come to play in creating liquidity for both the financial markets and economy, including inflated corporate cash flows and profits. Following 2004’s massive central bank dollar security purchases, speculative leveraging, unwinding of hedges, and marketplace dislocation-induced Over-liquefication, market players and economic agents throughout are taking liquidity excess for granted. This is a mistake. The speculative liquidity-creating mechanism is vulnerable, and problematic whether the Bubble continues or bursts.
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