If I read Noland right the end of ZIRP could be the beginning of the end for the markets
prudentbear.com
“Blow-off” Analysis:
I too frequently use the terminology “Blow-off” when discussing this extraordinary Credit Bubble environment. An email from a reader has provoked an attempt on my part to place a little meat on the “Blow-off” Analysis bone. To be sure, “Blow-offs” are a prominent aspect of my Macro Credit and Credit Bubble analytical frameworks, as well as a key feature of today’s market and economic backdrop.
It is tempting to simply exclaim, “We know it when we see it!” And, yes, “Blow-offs” are rather obvious in hindsight. One can explore market history and easily identify the manic behavior of stock market speculators such as what transpired in the U.S. during 1928/29, Japan in 1988/89, and global technology stocks in 1999/early 2000. To note a few in other markets, there was the spectacular precious metals run in 1979/80, the U.S. bond market in 1992/93, South East Asian financial markets in 1995/96, and 2004-to-present in U.S. housing markets. A shallow analysis of market “Blow-offs” would have us focus on end-of-cycle bouts of marketplace irrationality, where the full-throttle pursuit of perceived easy speculative gains comes at the expense of disregarding mounting risks. Market psychology is certainly a critical facet, but there is much more to these fascinating processes than simply The Crowd going nuts.
I have repeatedly declared that we are in the midst of historic “Blow-off” dynamics throughout U.S. and global Credit systems, and that these forces are behind myriad asset market and economic Bubbles. Well, first of all, it is critically important to appreciate that a major systemic “Blow-off” period, virtually by (my) definition, is a manifestation of deep-seated Monetary Disorder fostered by a confluence of factors. It is my view that financial historians have focused mostly on the (engrossing) irrationality and the “madness of crowd” aspects at the expense of more fruitful (but hopelessly plodding) analysis of underlying financing mechanisms.
When a “Blow-off” is in full bloom, The Crowd will never look in the mirror and appreciate that things are getting out of hand. At the same time, the curmudgeons will always be easily dismissed when fortunes are being made and finance is deluging those most aggressively profiting from “Blow-off” inflationary manifestations. “Blow-off” analysis is unconventional and has no hope of becoming mainstream. Let’s face it, there is no constituency for analyzing, identifying or dealing with “Blow-offs,” while the (increasingly) powerful interests will go to great lengths to rationalize and sustain them.
There will be little inclination to understand the typical proliferation of new types of Credit instruments, methods of Credit intermediation, and avenues for speculation; not with the propensity for bullish obsessions with New Paradigm and New Economy hyperbole. It will be the wonder of the real economy’s productivity and new technologies - and not evolving Credit system nuances and excesses - that receives distinction and glory. Nonetheless, a focus on Credit creation mechanisms, the nature of system-wide liquidity generation (“Monetary Processes”) and speculative dynamics provide a sound framework for analyzing and appreciating an atypical and risky environment destined to bamboozle the vast majority. Always, somewhere in the bowels of the Credit mechanism there are atypical developments fostering an extraordinary over-issuance of finance (“Credit Inflation”). But where, and what are its fragilities?
Fundamentally, “Blow-offs” arise inherently as a consequence of an extended period of overly abundant – and generally inexpensive – finance (“easy money”). End-of-cycle liquidity excess is as much A State of Mind as it is a State of the Credit System. They are about the powerful interplay of a broad consensus of bullish market perceptions and a well-oiled infrastructure for lending and financing speculation. There must be both wholesale Risk Embracement throughout the marketplace and a bountiful supply of finance made available through various Financial Sphere avenues.
Only after years of economic expansion and asset price inflation does the financial sector infrastructure evolve to the point of having the required capacity for a substantial step-up in issuance. For example, it took years of moderate expansion before the GSE’s had garnered the infrastructure and market confidence necessary for the commencement of the spectacular agency debt issuance boom in the late-nineties. A period of gradual success was necessary before the more recent ABS issuance boom, as well as the current explosion of “private-label” mortgage-backed securities. Each year of fortune entices a firmer push of the risk envelope, nurturing progressively looser Credit Availability and higher-yielding risky loans for securitization. And, only following years of strong returns did finance inundate the leveraged speculating community. It required years of asset inflation and relatively uninterrupted economic growth before the financial sector was willing and able to accommodate a household sector that came to be eager to adopt no-down-payment, adjustable-rate and negative-amortization mortgages in a borrowing spree surpassing $1 Trillion annually.
One cannot overstate the significance that the passage of time plays in nurturing Credit System “Blow-offs.” Major “Blow-offs” occur only after years of rising securities and real estate prices and, importantly, recoveries from various asset market stumbles, scares and serious set-backs. Each recovery works to embolden and empower, and multiple layerings of both are prerequisites for once-in-a-lifetime complacency. Those with the bullish determination to “buy the dips” are aptly and repeatedly rewarded, garnering ever greater control over marketplace assets and influence. The most bullish and aggressive risk-takers generally rise to the top levels of investment management, corporate management, lending, investment banking and finance generally (not to mention law, accounting and consulting). And, importantly, each “redemption” solidifies the (inflating) reputations of policymakers, whether the Federal Reserve, the Administration, Congress or the regulator community. Only recently has the media so boisterously trumpet the sublimity of the Federal Reserve and the incredible “resiliency” of the U.S. economy.
I believe the widespread perception that policymakers are prepared to bolster the boom - and will definitely not tolerate a bust - is an integral factor associated with major (throw caution to the wind) Credit System “Blow-offs.” And, as we have all witnessed, the more encompassing the effects of asset inflation and speculation, the more cowering policymakers become with respect to reining in excesses. Importantly, the confluence of late-cycle general Risk Embracement, lending and speculating excess, buoyant asset prices and (inflationary) boom-time economic “resiliency” ensure that only determined policy restraint will thwart the escalating whirlwind of “Blow-off” repercussions. Any timidity and pandering from the monetary authority will be readily rewarded with only greater Monetary Disorder and instability. And, I’ll add, typical monetary policy doctrine (certainly including perfunctory “rules”) is basically inapplicable once major “Blow-off” dynamics take hold.
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Administering cautious “restraint” (a.k.a. Greenspan “baby-steps”) may indeed appear a reasonable approach. After all, such a policy prescription might in more normal circumstances actually orchestrate the coveted “soft-landing.” Not, however, during Credit system “Blow-offs.” To accommodate Credit and speculative excesses is only to guarantee a protracted and highly dangerous Credit cycle culmination. Indeed, the intensity of financial and economic excess during major Credit System “Blow-offs” negates the potential for soft-landings. Rather, boom and bust dynamics govern; to prolong the boom is to secure a more problematic bust.
It is a central tenet of Credit Bubble and, more specifically, “Blow-off” Analysis that risk rises exponentially during the late, terminal stage of excess. At some point, Credit creation reaches a crescendo where a major Bubble attains sufficient dimensions to create system over-liquidity sufficient to spur the wholesale formation and expansion of myriad individual Credit and asset Bubbles (Mises “crackup boom”?). Just such a circumstance was realized with the U.S. Mortgage Finance Bubble. Massive U.S. Current Account Deficits have now become the major impetus for economic and asset Bubbles internationally, as well for as the major inflations throughout global energy and commodities complexes. Confirming Macro Credit Theory, Credit excess begets Credit excess and one Bubble begets the next. Market inflationary expectations have reached the extreme state where virtually all prices are expected to rise – stocks, bonds, real estate, energy and commodities. Both Credit expansion and (leveraged) speculative excess have become all-encompassing.
At this precarious stage of excess, players across the broad array of inflating asset markets perceive unlimited liquidity. And as long as asset markets rise, additional liquidity will be forthcoming. But there is no getting around the reality that to sustain the “Blow-off” phase demands enormous and unrelenting new finance. The nature of the “Blow-offs” ever greater appetite for new finance leaves it inherently vulnerable.
It was curious Tuesday and again today to observe the tight interplay between various markets. One can be pardoned for sensing that a rally in the yen was the catalyst for selling in a broad range of markets including energy, precious metals, commodity currencies, bonds, and global equities. There is certainly good reason to suspect that the “yen carry trade” (borrowing in yen and/or shorting low-yielding yen-denominated securities and using the proceeds to finance holdings in inflating markets) has ballooned to massive proportions and has, in the process, become a Seminal Source of “Blow-off” Finance.
To what extent the “yen carry” has been financing the leveraged speculating community, hence the U.S. securities markets, commodities, emerging markets and gloabl M&A, I am in the dark. But the size of The Trade is undoubtedly enormous, and the Japanese recovery is demonstrating impressive momentum. There will be pressure on the Bank of Japan to (belatedly) normalize interest-rates, both increasing the global cost of funds and narrowing interest-rate and asset-return differentials. The BOJ today appears in little hurry to raise rates, but I nonetheless would not be surprised to see the seasoned speculators a bit anxious for the exits in what could be one of history’s most “crowded trades.” If so, we have a first crack in the façade and a potential “Blow-off” antagonist. “Blow-offs” are especially dangerous for their capacity to surreptitiously inundate financial markets and economies with liquidity emanating from leveraged speculation. And they inevitably come to an end with speculator de-leveraging. |
