Compare & Contrast: 2011 vs. 2008:
Doug noland
prudentbear.com
I thought a paragraph from today’s Financial Times (“This is Not a 2008 Redux,” Jennifer Hughes) succinctly captured the consensus view:
“At the bottom of all of this is a lurking fear that this is 2008 all over again. But it is not. Since then banks have written down swathes of dud loans and assets, they have built up capital and most immediately important, they have access to central bank liquidity should the market freeze up. Granted, major banks back on life support would, and should, send markets reeling, but the central bank option means investors would not face the cliff-edge event that was Lehman’s collapse.”
With astonishing market volatility, faltering marketplace liquidity, collapsing global bank stocks and the imposition of limited bans on short-selling, the unfolding global financial crisis this week definitely recalled the 2008 experience. As the FT noted, there are important differences. There are, as well, some critical similarities. I thought it was worth delving into a little “Compare and Contrast” – from my analytical perspective.
First of all, the nucleus of the current crisis is in Europe instead of the U.S. financial system. I have for awhile now posited the thesis that policy responses to the 2008 meltdown unleashed a perilous “global government finance Bubble.” The first crack in the latest Bubble developed in the eurozone (Greece), as opposed to the 2008 crisis that emerged at the fringe of U.S. mortgage finance (subprime). Our banks and Wall Street firms were the focal point of 2008 market fears, while it is today the European banking system. It is certainly easier these days for U.S. pundits, analysts and investors to remain complacent – and content to believe that market selling has been way overdone.
Global policy responses to the 2008 turmoil emboldened the view that policymakers retain powerful tools to manage financial crises. A key facet of my bearish thesis is that the bursting of the “government finance Bubble” will find policymaking increasingly ineffective and, in the end, incapacitated. A Bubble fueled by massive fiscal and monetary stimulus nurtures inevitable vulnerability to the waning capacity of these measures to sustain inflated markets and maladjusted economic structures. As we’ve witnessed in the European periphery (and, to a lesser extent, here at home), massive government stimulus reaches a point of diminishing returns. And when a crisis of confidence unfolds in government debt – as has been the case in Greece, Ireland, Portugal, Spain and Italy – newfound policymaking constraints quickly become a focal point of market worries.
Yet, a well-entrenched view holds that governments can simply create liquidity and boost bank capital, ensuring no repeat of the “cliff-edge event that was Lehman’s collapse.” Policymakers have supposedly learned from past mistakes. Especially this week, with market attention turning to French and European banks, market debate centers around the capacity for the ECB and European governments to support their fragile banking system.
I’ll again borrow the phrase “a banking system is only as good as its sovereign.” In major contrast to 2008, the issue today is not the vulnerability of heavily leveraged banking systems to a crisis of confidence in private (mainly mortgage) debt and sophisticated “Wall Street” structures. Crisis 2011 is foremost a sovereign debt issue – and this changes things profoundly. Since ‘08, governments have issued Trillions of new debt and, at the same time, have assumed enormous amounts of private-sector risk. Increasingly, governments are losing their capacity to underpin financial systems and economies through additional debt issuance. To keep the latest Bubble from imploding, markets are demanding that those sovereigns that retain the capacity to take on huge additional burdens do so in order to more generally backstop faltering debt structures.
The cost of protecting against a sovereign default by France (in the Credit default swap/CDS market) traded above 180 bps this week, compared to a high of about 65 bps back during 2008 market tumult. Importantly, a crisis that began last year at Europe’s periphery has now afflicted its core. On the one hand, markets expect France and Germany to backstop the faltering eurozone debt structure (sovereign and banking system). On the other, the marketplace is recognizing that the enormity of such an undertaking risks pushing French debt over the proverbial cliff. In contrast to ’08, the pressing issue today is not susceptible firms such as Bear Stearns or Lehman – but (G7) nations such as Italy and France. Already weighed down by holdings of impaired periphery debt, the French banking system is clearly vulnerable to any waning market appetite for French sovereign Credit.
Italian CDS traded above 400 last week, double the 2008 high. Throughout the CDS marketplace, prices (especially the past week) have surged to levels significantly above those from the heart of the 2008 crisis. In the past seven sessions, CDS prices have jumped 36 bps (to 151) in Brazil and 33 bps (to 152 ) in Mexico. In general, the CDS market appears impaired. This week in particular, “emerging” currencies and debt markets turned tumultuous – and worryingly 2008-like, only compounding banking and market worries. Importantly, mechanisms that transmitted instability around the globe back in 2008 are very much intact in 2011.
We’ve all listened to the argument “there’s less leverage in the system now than in 2008.” Well, I’ll assume that much of the egregious speculative excess in high-yielding U.S. mortgage Credit was wrung out of the system (not so confident the same can be said for “AAA” mortgage exposure). Clearly, the U.S. banking system has been much more cautious in their exposures to mortgage and private-sector debt, although there have been ample excesses in corporate “leveraged finance”. I’ll also assume that Wall Street balance sheets are less vulnerable now than in 2008. But when it comes to the global leveraged speculating community, I’m not so convinced that they are any less exposed to tumultuous markets than they were in 2008. And with counter-party risk again an issue, I increasingly fear for the stability of the nebulous entity referred to as “the global derivatives marketplace”.
When the leveraged speculators (hedge funds, proprietary trading desks, etc.) were caught poorly positioned during a faltering U.S. mortgage finance Bubble back in 2008, their problems swiftly became the global financial system’s problem. As they were throughout the 2008 crisis, the leveraged players remain the predominant transmission mechanism from one market to virtually all markets. As losses mount, speculators are forced to reduce risk and leverage throughout the global risk markets. In our highly interlinked global marketplace, liquidity issues and market dislocation in a key market rather quickly evolve into de-risking, de-leveraging and liquidity issues throughout.
Post-2008, a rejuvenated hedge fund community grew to record size (surpassing $2 TN). From my vantage point, their market influence seems as great as ever – at least it appeared so this week. And I’ll venture a guess that leveraged “carry trade” speculations are greater in scope today than was the case in ‘08. An important aspect of “global government finance Bubble” analysis is that the sophisticated players were emboldened – and highly incentivized - by post-’08 government reflationary policymaking. In particular, financial and economic vulnerability ensured extremely low interest rates (and currency devaluation) in the “developed” world, while strong (domestic and global) inflationary biases virtually guaranteed higher returns and strengthening currencies for the “developing” economies/markets. While this trend – along with attendant speculation – was prominent leading up to the 2008 crisis, I fear speculative excesses might have been on an even grander scale over the past two years.
The scope of global “carry trades” (i.e. take the proceeds from shorting/selling a low-yielding currency to speculate in instruments from higher-returning currencies) is a big unknown. How much shorting of dollar instruments (i.e. Treasurys and such) has funded leveraged speculations in the “developing” markets is a question I ponder on a daily basis. We do know that the enormous global “macro” funds have become much bigger and richer since 2008. And, from what I can discern, their returns have seemed to be at least somewhat negatively correlated to the dollar.
Currency markets turned unstable this week. Meanwhile, global risk markets – certainly including the emerging currency, equity and debt markets – became highly correlated. Market action seemed to confirm the view of heightened market vulnerability to the unwind of leveraged “carry trades.” Or, at least, the market became increasingly nervous about the ramifications from weakness in the higher-yielding currencies (quite reminiscent of 2008).
From a high of 1.60 (to the $) in July 2008, the euro sank to 1.25 during the worst of the crisis that October. On a fundamental basis, the euro would appear much more vulnerable today than it was during 2008. And while I would assume that there has been less speculative long buying buoying the euro of late, there has likely been significant hedging activity to protect against a major euro breakdown. This type of hedging activity would tend to increase volatility – which has been the case recently. And it would also increase the risk of an accelerating euro decline – and general currency market instability – in the event the euro begins to break through important levels. This is a big market worry.
From my perspective, the post-2008 landscape has been one of myriad Bubbles enveloping the globe. I believe China is in the midst of a historic Credit Bubble. Looking at rampant Credit and speculative excesses throughout the “developing” markets, I see ample confirmation of the Bubble thesis there as well. In hindsight, it should be indisputable that the massive issuance of debt (at artificially low borrowing costs) throughout the European periphery was a major Bubble. And I am very comfortable with the view that Washington policymaking – and resulting dollar devaluation – were fundamental to the global inflationary Bubble backdrop. From my perspective, the Treasury market has evolved into a most precarious Bubble of mispriced finance, over-issuance and severe market distortions of great consequence.
Analysis is a lot simpler in hindsight. From my analytical perspective, the sequence of how these global Bubbles might falter wasn’t obvious. Who would go first? China, Europe, “developing,” Treasurys, etc. The sequence would make a big difference on how things would be expected to unfold. Now, with the bursting of the sovereign debt Bubble in Europe, kindred Bubbles are impacted and in heightened jeopardy. Markets are under pressure, finance has tightened meaningfully, and faltering confidence is a major issue in Europe, the U.S. and beyond.
A strong case can be made that the global economy will prove less resilient than 2008. Credit excess over the past few years throughout the “developing” economies is a source of concern. China, Brazil, India, Russia, Mexico and others were at robust phases of their respective Credit cycles when the global crisis hit in 2008. Their markets, Credit systems and economies bounced back quickly - and proved the growth locomotive for global recovery. I fear recent excesses have created unappreciated vulnerabilities.
For now, Europe will likely remain the focal point. The continent’s debt structure is a major issue. Huge deficits have been financed by their banking sector. As confidence in sovereign debt falters, banking system stability crumbles. Here at home, we today enjoy a different dynamic. Most of our federal debt has been purchased by the People’s Bank of China, The Federal Reserve, The Bank of Japan and “developing” central banks around the world. In the short term, our debt structure is proving much more stable than Europe’s. Our banks look better by comparison – and our Treasury market appears bulletproof. The ECB has been forced into its version of “QE3”, while our divided Fed may not be as quick with additional quantitative easing as markets had expected. And perhaps, at least for now, we won’t have the world’s preeminent policy-induced currency devaluation – as the speculative trading world had confidently assumed. Or, stated differently, shorting dollars to fund inflating “undollar” risk markets around the globe might not be the sure bet many were presuming.
But let’s not digress… What we do know is that acute market instability has again reared its ugly head. Policymakers are reacting, of course. To this point, policy measures have succeeded in thwarting a breakdown. I am skeptical that policymaking will so easily stabilize the markets. The Fed’s move to pre-commit to “pegged” zero rates for a couple more years may somewhat benefit the leveraged speculating community – while throwing a volatile mixture on the Treasury Bubble. But who believes this is fair to savers or the right medicine for our economy? And Europe will be walking a tightrope, as they struggle to support the faltering periphery without imperiling the system’s core. And as contagion effects continue to mount, it will come down to the markets’ view of the German taxpayer’s willingness to backstop the continent.
Sovereign debt crisis means all the easy solutions have been expended – and all the proven and conventional ones as well. When former Federal Reserve Vice Chairman Alan Blinder was asked to comment on National Public Radio about the Fed’s new rate policy, he chuckled and said “they’re desperate.” I’ll assume it was nervous laughter. I will also presume that the marketplace will be increasingly unnerved that desperate policy measures risk destabilizing already highly unstable global markets (5% daily swings in equities; abrupt 4 point moves in bonds; 5% in currencies…). Are there any “safe havens”? There were in ’08. And all this equates to myriad market and economic uncertainties, including the risk of ongoing de-risking and de-leveraging. Best I can tell, the strongest bull argument going is that governments will support the markets. Well, the markets are in a world of hurt when that faith evaporates. This wasn’t much of an issue in 2008. |
