Excellent Doug Noland tonight:
Conundrums:
After reading Bill Gross’s latest, I felt compelled to muster some type of response. I was even quick with a title – “The McCulleyzation of Mr. Gross.” I struggled with whether I would use “The Disappointing McCulleyzation…” While disheartened, I reminded myself that in these uncertain times everything needs to be kept in perspective. He has his job to do. Understandably, his top priority is performing for his bond investors.
Nonetheless, I do take it as evidence of our upside-down financial world that the universe’s largest bond manager buys into the notion of insufficient global demand and a Bernanke Fed chairmanship. Is the world’s largest economy not in the midst of an ill-fated consumption boom, with the most populated countries on earth – China and India – embark on an historic increase in domestic consumption (along with investment)? Then there is the issue of Dr. Bernanke as a dogmatic standard bearer for continued artificially low U.S. and global rates, an environment today deemed untouchable by the entrenched financial powers.
The status quo is the problem and offers no solution. U.S. and global financial systems are dysfunctional, and continued accommodation of financial excess will end in tears, acrimony and the inevitable fanatical hunt for scapegoats. I very much fear this outcome. Today, the critical issue is not “insufficient demand” or a lack of global consumers, but an extremely uneven (and unstable) flow of finance both at home and abroad. Global asset inflation/Bubbles and massive speculative flows/Bubbles are creating only more extreme divergences in relative performances in sectors and economies across the globe. Yet such outcomes are the very essence of inflationary Credit and speculative Bubbles, and it is important to recognize that ongoing accommodation of current dynamics will only worsen imbalances, wealth transfers, and animosities. The current unjust distribution of wealth was underscored in today’s New York Times article by Mark Landler – “Europe: The Unlevel Playing Field – A union of Straggling and Booming Economies and Frustrations.”
“Like thousands of young Spaniards, Rafael Matito left his home village for Madrid 18 months ago, lured by one of Europe’s most thriving capitals. After landing a job as a computer instructor, he and his girlfriend set about achieving the Spanish dream: buying their own home. ‘We weren’t looking for a villa or anything close to it,’ Mr. Matito, 28, said. ‘We just wanted one or two rooms.’ Madrid was out of the question because of the sky-high prices, so they hunted in the suburbs. But even there, apartments were twice what they could afford. Disillusioned, they called off the search until the market cools - if it ever does. Spain is in the seventh year of a housing boom that with interest rates at historically low levels, shows no sign of cresting. Nearly two decades after joining the European Union, Spain is on the leading edge of an emerging, and troubling, dichotomy between dynamic European countries, with fast-rising asset prices, and lumbering countries, with moribund markets, most notably Germany. Far from converging into a more homogeneous bloc, the 12 countries that use the euro currency are dispersing into sprinters and laggards, with different levels of consumer confidence, industrial activity, and economic vigor. Bustling Ireland, with a growth rate of 5 percent, has little in common with becalmed Italy, where output may actually shrink this year. This has created a conundrum for the European Central Bank in Frankfurt, which sets interest rates for much of the Continent.”
Inflation manifests and alters behavior differently depending on myriad financial, economic, social, political and cultural factors. Today in Europe, rising home and energy prices place a drag on consumption and investment. In the U.S., the home equity extraction-crazed American consumer responds altogether differently; he borrows and spends more and blows additional hot air in the Bubble Economy. And while the strong inflationary bias that permeates the U.S. system, along with its Asian counterparts, continues to captivate the global pool of speculative finance, a restive Europe anxiously watches and waits.
The ECB’s conundrum with respect to increasing economic divergences and Mr. Greenspan’s conundrum with respect to U.S. low market rates are two faces of the same coin. And, in truth, there is no conundrum. Uneven financial flows, divergent economic performance, rising asset prices, and artificially low global bond yields are intrinsic byproducts of ongoing global Credit, liquidity, and speculative excess. The global currency "regime" is anchorless and without a moral compass. The U.S.-based global financial system is in the process of breaking down, the consequence of the Greenspan Federal Reserve accommodating protracted lending and speculating excess throughout “The Core” Credit system.
I have to this point disregarded “Bretton Woods Two” propaganda. The fanciful notion that the concomitant ballooning of U.S. current account deficits and Asian central bank dollar holdings comprise a stable and sustainable monetary regime reminded me too much of the convoluted New Paradigm metrics and “analysis” spawned during the late-‘90s manic technology circus. I am again reminded that there is a high correlation between the length of blow off periods and the capacity to relish nonsense. The current global currency arrangement evolved out of the necessity of managing escalating U.S. profligacy and the attendant precarious global financial flows. My notion is that Global Wildcat Finance is no more a lasting currency regime than wildcat banking was an enduring banking system. It works miraculously only while it works.
Many readers are likely familiar with Nouriel Roubini’s (of NYU) insightful work analyzing the U.S. Current Account. In his paper “The US as a Net Debtor: The Sustainability of the US External Imbalance” he points to “the scale of financial flows required to sustain the new “Bretton Woods Two” as the “Achilles heel.” According to Mr. Roubini’s cogent analysis, “…there are five reasons why this new regime will not prove to be stable. 1) Internal dislocation in the United States… Bretton Woods Two keeps U.S. interest rates below what they otherwise would be, helping interest rate sensitive sectors of the U.S. economy. However, the financing comes at the expense of import-competing sectors… 2) The strains placed on Europe… 3) The strains placed on China’s domestic financial system… 4) The financial risks associated with continuing to provide low-cost dollar denominated financing to the United States. Asian central banks are already taking an enormous financing risk by holding most of their reserves in dollar denominated assets… 5) Incentives to free ride and opt out of the cheap dollar financing cartel…”
I tend to lean toward the view that this strange global currency arrangement was fashioned more out of ad hoc urgency to manage destabilizing financial flows than an organized “cartel” to manipulate Asian currencies lower. What began with good intentions spiraled out-of-control right along with U.S. trade deficits. I thought the Financial Times’ Wednesday interview with Bank of Korea governor Park Seung was especially telling.
“Financial Times: Korea has very large foreign exchange reserves. What is the best way for Korea to manage those reserves? You’ve said you’d like to manage them more profitably. I know about the Korean Investment Corporation but what are the other options? And what about diversification?
Park: As we experienced in the 1997 currency crisis, we think that we have a stronger need for enough amount of foreign reserves. So in our management of our foreign reserves we of course consider profitability but we are also focusing on safety and liquidity. I believe that we now have sufficient reserves to secure our sovereign credibility, so I do not think we will increase the amount of foreign reserves further. Since we have sufficient foreign reserves at $200bn, which is the fourth largest in the world, I think we now need to take more consideration of profitability, and I think we’re at a stage where we need to manage our reserves in a more useful way…
Financial Times: Can I just clarify something. You said that you have sufficient reserves now and that you will not need to increase them further. Does that mean you will not be intervening in the foreign exchange markets?
Park: No, no, we will not be intervening. (Later in the interview, Park Seung clarified: “I said we will not increase our foreign reserves but actually we do not anticipate increasing our foreign reserves. We are trying to manage our reserves more usefully and the current account surplus is decreasing so we do not expect foreign reserves to increase.”) In fact the Bank of Korea is not doing any intervenion in the foreign exchange markets to defend the exchange rate, we are just doing smoothing operations.”
“Bretton Woods Two” proponents are content to extrapolate the enormous growth in Asian central bank balance sheets over the past few years. But bankers such as Mr. Park are undoubtedly today cognizant of the risks associated with continued monetization of U.S. Current Account deficits. There are internal domestic economic and financial issues, as well as the risk of loss on dollar assets. And one should expect the enterprising Chinese to join the Korean bankers in the pursuit of “profitability” with respect to their reserve position. Would they play against the hedge funds?
There are various estimates of the interest-rate “subsidy” that Asian central bankers are providing the U.S. bond market. Mr. Gross conjectured about 100 basis points. And while there is certainly a “subsidy,” lower market yields are only one facet of what has evolved into major marketplace distortions. The bottom line is that Asian central banks are acquiring a very significant portion of new Treasury issuance. This unusual dynamic takes on particular significance with Treasury bonds holding down the status of global yield anchor. It becomes of even greater relevance when Treasury bonds are the key vehicle used (shorted) for the enormous speculative “spread trade,” as well as the predominant security traded for interest-rate hedging purposes. I argue that Credit market speculating and trading dynamics have been profoundly distorted by central bank purchases, and this is a key aspect of today’s general Monetary Disorder.
This is my 16th year managing money on the “short-side.” I have, more times than I care to recall, witnessed first hand the dynamics of “short squeezes.” And it is those unusual episodes where the bears have shorted a high percentage of the outstanding “float,” while a “cartel” of longs has “locked away” most of the tradable stock, when the stage has been set for wild trading, manipulation, and spectacular speculative gains – only to be followed by inevitable collapse. And it is a fascinating aspect of speculative dynamics that these “squeezes” too often develop right as negative fundamentals begin to manifest, although it is the rapidly rising stock price that proves the powerful impetus for hype and duplicitous promotion. In certain environments (1999/early 2000 comes to mind), the general backdrop becomes so conducive to systemic squeezes that fundamental analysis is cast aside en masse for the fun and easy profits afforded “squeezing the shorts.”
Squeezes, manipulation and propaganda are facts of life for highly speculative markets. They are also an important, yet disregarded, aspect of Monetary Disorder and the breakdown of the market pricing mechanism. There is colored history of stock market Bubble antics and their consequences, certainly including the late-twenties debacle, Japan in the last-eighties and NASDAQ from not many years ago. That similar dynamics have taken such prominent hold of our Credit market/system is an extraordinary and very troubling development that cannot be measures in subsidies or basis points. And I can’t stress this enough: Bubble dynamics in stock markets are very dangerous; Major Bubbles in the U.S. and global Credit systems are an unmitigated disaster for many reasons, certainly including that no one will be willing to stand up and make the difficult decision to rein in excesses.
It is both reasonable and tempting to look to the imbalanced U.S. economy, stagnant Europe, heightened risk to Asian Central Banks, and a fragile Chinese financial system for the “Achilles heel” of the so-called “Bretton Woods Two regime.” It is my view, however, that U.S. financial markets may very well be the first to buckle under. The weak link in this mechanism is that it today fully accommodates ongoing U.S. lending, leveraging and speculating excess. Resulting Current Account Deficits are then recycled right back to U.S. markets, exacerbating Bubble excess throughout.
It is my view that the resulting over-liquefication has already severely distorted market dynamics, including overly rewarding aggressive leveraged speculation (“carry” and “spread” trades, for example). And rewarding speculation – in this global environment of rampant liquidity excess – only enlarges the global pool of speculative finance. Importantly, the distorted marketplace is over-financing the Mortgage Finance Bubble – the greatest danger to financial and economic stability. Here, a confluence of massive speculative leveraging, derivative hedging, and artificially low Treasury yields has fostered a breakdown in the pricing mechanism for mortgage finance. The demand for mortgage Credit has today become irrelevant to the cost of borrowing, in what has developed into the most powerful mechanism for lending, speculative excess, and liquidity creation in history.
There is today false-confidence that we are enjoying a free lunch – that we can both import cheap imported goods and offload financial risk to Asian central banks. Overwhelmingly, however, financial risk mounts right here at home with our inflated securities market prices, increased speculative leveraging, and escalating late-cycle mortgage risk creation. In all cases, risk will compound every day that U.S. Current Account Deficits are recycled back into Dysfunctional U.S. Market Processes. And the current surge in liquidity and decline in mortgage yields - at this Mortgage Finance Bubble blow off stage - is the worst-case scenario.
There is today complacency that financial fragility and economic vulnerability ensure low yields – say 3 to 4% - as far as the eye can see. And even Alan Greenspan this afternoon implied that, since mortgage borrowers are increasingly stretched, the housing market can be expected to soon cool. This is wishful thinking quite detached from Bubble analysis and realities. The U.S. financial system is the vulnerable “weak link” specifically because of the confluence of unusual marketplace dynamics and the Mortgage Finance Bubble. A spike in yields would be immediately problematic, while the nature of market dynamics (unprecedented leveraging, speculation, and derivative hedging) engenders major self-reinforcing directional market moves (higher or lower). At the same time, the “Bretton Woods Two” recycling of finance into the Treasury market and recent heightened financial stress (GM, hedge funds) has created a powerful inflationary bias for the Treasury Bubble (proclivity for higher prices), pulling market yields sharply lower. This ensures only more destabilizing mortgage Credit excess and escalating late-cycle systemic risk.
The ongoing rampant flow of finance into already inflated markets is a serious dilemma for the U.S. financial system. Credit market prices are unattractive. The risk-reward profile of the stock market is anything but enticing. The sure thing of investing in the hedge fund community isn’t looking so sure. At the same time, the reliable reflation trade is demonstrating the innate risk characteristics of over-liquefied speculative finance. And, importantly, the deteriorating quality of mortgage Credit is ongoing, with this year’s estimated $2.4 Trillion of originations much riskier than last year’s. There are Credit and speculative dynamics at work very similar to those that distorted corporate risk market dynamics and prices, leading to the GM debt fiasco. Indeed, it is this precarious mix of the inherent instabilities of leveraged speculation and mortgage Credit excess that ensure the early demise of “Bretton Woods Two.”
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