Page 1 of 3 CREDIT BUBBLE BULLETIN Weakness is king
Commentary and weekly watch by Doug Noland
Legendary former Federal Reserve chairman Paul Volcker spoke again last week before the New York Economics Club. I've included large portions from his talk below. As a member of the Federal Reserve going back to the early 1950s, Mr Volcker offers incomparable experience and insight. The comments from this honorable statesman are always worthy of careful consideration.
Mr Volcker has myriad issues with contemporary central banking and is no fan of the Fed's dual mandate. When asked for his preferred central bank mandate, he referred to the Bundesbank
and monetary stability before providing the following: "A central bank is in charge of the currency. And the responsibility is for a stable currency."
Well, we live in an era where global central banks prefer weak currencies to stable ones. Almost in unison, today's monetary policy doctrines push currency devaluation. It's essentially this period's "beggar thy neighbor", cloaked in analytical elegance and sophistication. The Ben Bernanke Fed's loose policies have weakened the dollar for years now.
Monetary stimulus went to unprecedented extremes after the bursting of the mortgage finance bubble, an inflationary course that was fatefully ramped significantly higher last summer with the move to open-ended quantitative easing (QE). More recently, the Bank of Japan embarked on an extraordinary (and similarly fateful) monetary experiment to weaken the yen and inflate the price level.
It seems rather obvious that years of aggressive synchronized monetary stimulus have indeed fueled the greatest bubble in history. More than four years ago, I presented the "global government finance bubble" thesis. The "developing" markets and economies have been integral to my macro credit and bubble analysis. The conventional bullish view has held that China, Asia, Latin America and Eastern Europe were the "global locomotive" that was to pull the struggling developed economies out of the muck. I've taken a much dimmer view. Unprecedented monetary excess from the Fed and others helped push already overheated "developing" credit systems and economies into dangerous "terminal phase" credit bubble excess.
There are always unintended reflationary consequences. The Fed's US$85 billion monthly QE has spurred a powerful bubble throughout US securities and asset markets. The unintended include the reemergence of "king dollar" dynamics and the magnetic pull of speculative finance from the "developing" markets. The Bank of Japan has succeeded in weakening the yen, but at the expense of South Korea and "developing" Asia. The weak yen has further bolstered "king dollar", placing additional pressure on commodities markets, economies and currencies.
From Bloomberg: "China's economy is proving less responsive to credit, escalating pressure on Premier Li Keqiang to strengthen the role of private enterprise. The government's broadest measure of credit rose 58% to a record 6.16 trillion yuan (US$1 trillion) in January-to-March, when gross domestic product gained 7.7%, compared with 8.1% a year earlier. Each $1 in credit firepower added the equivalent of 17 cents in GDP, down from 29 cents last year and 83 cents in 2007, when global money markets began to freeze..."
Other headlines of note last week: "India's Economic Growth Slowest in a Decade"; "India's Bonds Complete Worst Week Since March..."; "Brazil Faces 1970s Stagflation as Resource Boom Wilts"; "Latin America Disappoints After Squandering Commodity-Boom Era"; "BRIC - Worst Growth Sinking [Brazil's] Corporate Debt Market"; "China Slowdown Drives Asia Bond Risk Above Peers"; "Mexico Bond Yields Rise to Highest Since January; Peso Declines"; "Turkey's Trade Gap Balloons in April Sending Bonds, Lira Lower"; "Biggest Selloff Since 2011 Hammers [South African] Bonds"; and "Russia Yields Surge Most in Month... as Ruble Slides".
The more analysts dig into the analysis the less they like what they see. For the week, the South African rand dropped 5.1%. The Brazilian real sank 4.2%, the Chilean peso declined 2.5%, the Malaysian ringgit 2.0%, the Hungarian forint 2.0%, the Peruvian new sol 2.0%, the Mexican peso 2.1%, the Russian ruble 1.6%, the Philippine peso 1.6%, the Turkish lira 1.5% and the India rupee 1.5%.
Despite a surprise 50 basis point (bps) increase in rates, the Brazilian real traded to a four-year low last week. It is worth nothing that Brazil's local 10-year government yields jumped just over 100 bps during May to 10.48%. Mexico's 10-year local yields rose almost 100 bps to 5.45%. Russian yields were up about 80 bps for the month to 7.28% and Turkey's yields were up 70 bps to 6.71%.
May was similarly unkind to many "developing" equities markets. Brazilian and Mexican stocks were down 3.6% and 1.6%. Argentine stocks (Merval) were down 9.3%, Peru 7.5%, and Chile 2.4%. Eastern Europe was generally mixed, while developing Asia was mostly positive for the month. Most commodities suffered a difficult May. The CRB Commodities index declined 2.1%. Lumber was down 9.7%, Cocoa 9.3%, Natural Gas 7.9%, Coffee 5.5%, Sugar 4.5%, Silver 4.6%, Gold 3.7%, Cotton 3.3% and corn fell 2.9%.
US equities for the most part enjoyed a carefree May. The S&P500 rose 2.1%. The average stock (Value Line Index) jumped 3.9%. The small cap Russell 2000 gained 3.9% and the S&P400 Mid-Cap Index rose 2.1%.
And the more speculative the better. The Nasdaq Composite rose 3.8%. The Nasdaq Telecom index gained 6.2%, the Interactive Week Internet index advanced 4.8%, the Philadelphia Semiconductor (SOX) Index gained 5.5%, and the Nasdaq Biotech index jumped 4.1%. The KWB Bank index surged 8.3% and the NYSE Securities Broker/Dealer index jumped 9.6%. The Goldman Sachs Most Short Index gained 5.1% during May (up 23.2% y-t-d).
Curiously, financial euphoria took hold in US risk markets just as "developing" markets began indicating mounting fragility. Considering the degree of exuberance that has taken hold here at home, we should not be surprised that our markets have dismissed the relevance of heightened currency, commodity and "developing" market weakness. Actually, as the US equity market has succumbed to speculative dynamics, global macro concerns have only worked to provide additional fuel for the "melt-up". May was a big short squeeze month, and those shorting the US markets were repeatedly forced to cover as the market lurched higher.
Financial Euphoria also helped see the backup in US market yields in positive light. May saw 10-year Treasury yields jump 46 bps. Notably, benchmark Fannie Mae mortgage-backed securities' (MBS') yields surged 61 bps. With the Fed on deck to buy large quantities of Treasuries and MBS for months to come, it was easy not to take the backup in yields too seriously. Actually, most viewed higher yields as confirmation of their bullish thesis.
There's an alternative bearish view worth contemplating: in the midst of all the euphoria, the global "system" actually commenced another de-risking and de-leveraging cycle. Huge amounts of leverage have accumulated in highly speculative global markets over the past four years - from global currency "carry trades", to commodities, "developing" market debt, and even US corporates and MBS. Seemingly annual bouts of impending market tumult have been held at bay by aggressive central bank intervention. This one has started in the midst of unprecedented monetary stimulus from the Fed, Bank of Japan (BOJ) and others.
I'm of the view that the so-called "global reflation trade" became one enormous speculative bet on unending dollar devaluation, China/Asia expansion, commodities inflation and Latin American growth. Yet on almost all fronts, this scenario is increasingly challenged. "King dollar" dynamics have overwhelmed Bernanke Fed dollar devaluation.
China, in particular, and "developing" economies more generally suffer from myriad ill-effects of years of rampant credit expansion and attendant imbalances and fragilities. Moreover, additional easy money and stimulus would only worsen the situation. Commodities markets have weakened, partially as a result of deteriorating China/Asian/"developing"/global growth dynamics.
Furthermore, commodities prices tend to come under pressure in anticipation of more aggressive exports by the increasingly vulnerable "commodities" economies. Recall how the collapse of the soviet empire (and then Russia) pressured the price of about everything those countries had to sell?
There are aspects of the current environment that are reminiscent of 1998. US equities were on a bull run - fueled by liquidity abundance coupled with the bullish perception that global macro issues had been resolved by the International Monetary Fund and global central banks. It was at the time difficult for me to believe that the markets were ignoring the unfolding Russian debacle - confident that "the West would never allow Russia to collapse". And, importantly, the marketplace was oblivious to unfolding derivative problems that manifested in the collapse of Long-Term Capital Management. Again, the view was that global central banks would not tolerate a major derivatives blowup.
Well, the global "system" has had more than four years of ongoing artificially low rates, unprecedented liquidity overabundance and central bank market backstopping that would seem to ensure the accumulation of all varieties of financial excess. And as far as I'm concerned, this latest speculative run in US stocks is just one more excess adding to already major global fragilities. It's worth noting that stocks, commodities and bonds all were in retreat on Friday. At least for a day, it had the look of de-risking, de-leveraging and waning liquidity.
There's always that thin line between fervent speculative excess along with the perception of unending liquidity abundance and a vulnerable speculative bubble. Emerging market (EM) funds suffered their worst week of outflows since December 2011. In the '90s, the emerging markets came to be called "roach motels". Part of the ongoing EM bull story has been the large accumulation of international reserves by these economies - that would ensure no '90s-like repeat of "hot money" flight and attendant financial and economic dislocation.
To what extent these reserve holdings enticed only larger "hot money" inflows is today a pertinent issue. Also apropos is the consequence to market liquidity if the EM central banks were forced to sell some of their reserve holdings to support their currencies against a "hot money" (de-risking/de-leveraging) run to the exits.
And we can't forget the crowded - and potentially weak-handed - global leveraged speculating community and their ongoing struggles for decent performance. The yen gained almost 1% last week versus the dollar, as Japanese stocks were hammered. The Abe/Kuroda bubble is suffering a credibility crisis. It's going to be another interesting summer.
From "Central Banking at a Crossroad," Paul Volcker, The Economic Club of New York, May 29, 2013:
"In no doubt, the challenge of orderly withdrawal from today's (vs 1950s) broader regime of quantitative easing is far more complicated. The still growing size and composition of the Fed's balance sheet implies the need for, at the least, an extended period of disengagement. Moreover, the extraordinary commitment of Federal Reserve resources alongside other instruments of government intervention is now totally dominating the largest sector of our capital markets - that for residential mortgages.
"Indeed, I do not believe it an exaggeration to note that the Federal Reserve with assets of $3.5 trillion and still growing is, in effect, acting as the world's largest financial intermediator, by acquiring long-term obligations and financing short-terms, of course aided and abetted by the unique privilege to create its own liabilities.
"Beneficial effects of the actual and potential monetization of public and private debt - the essence of the various QE programs - appear limited and diminishing over time. The old 'pushing on a string' analogy is relevant. And the risks of encouraging speculative distortions and the inflationary potential of the current approach plainly deserve attention. All of this has given rise, obviously, to debate within the Federal Reserve Board itself. In that debate, I trust sight is not lost of the merits - economically and politically - of an ultimate return to more orthodox central banking approaches.
"I do not doubt the ability and the understanding of chairman Bernanke and his colleagues. They have a very considerable range of tools and instruments available to them to manage the transition. They include the novel approach of paying interest on excess reserves, potentially sterilizing their monetary impact. What is at issue - what is always at issue - are matters of good judgment, leadership and institutional backbone. The willingness to act with conviction in the face of predictable political opposition and substantive debate is, as always, a requisite part of a central bank's DNA.
"Those are not qualities that can be learned from textbooks. Abstract economic modeling and the endless regressions of econometricians will be of little help. The new approach of 'behavioral' economics itself is recognition of the limitations of mathematical approaches, but that new 'science' is in its infancy.
"I think a reading of history may be more relevant. Here and elsewhere the temptation has been strong to wait and see before acting to remove stimulus and then moving toward restraint. Too often the result is to be too late, to fail to appreciate growing imbalances and inflationary pressures before they are well ingrained.
"There is something else beyond the necessary mechanics and the timely action that is at stake: the credibility of the Federal Reserve, its commitment to maintain price stability and its ability to stand up against pressing and partisan political pressures is critical. Independence cannot be just a slogan. Nor does the language of the Federal Reserve Act itself assure protection, as was demonstrated in a period after World War II. Then, as now, the law and its protections seem clear, but then it was the Treasury for a long time that called the tune.
"In the last analysis, independence rests on perceptions of high competence, of unquestioned integrity and the will to act. Clear lines of accountability to the Congress and to the public need to be honored. Moreover, maintenance of independence in a democratic society ultimately depends on something beyond those internal institutional qualities. The Federal Reserve - any central bank - should not be asked to do too much - to undertake responsibilities that it cannot responsibly meet with its appropriately limited powers.
"I know it's fashionable to talk about a dual mandate - that policy should somehow be directed to two objectives of price stability and full employment. Fashionable or not, I find that mandate both operationally confusing and ultimately illusionary. Operationally confusing and in breeding incessant debate in the Fed and the markets about which way policy should lead - month to month, quarter to quarter - with close inspection of every passing statistic. More important, illusionary implies a tradeoff between economic growth and price stability - a concept that I thought had been long refuted not just by Nobel prize winners but by experience.
"The Federal Reserve, after all, has only one basic instrument so far as economic management is concerned - managing the supply of money and liquidity. Asked to do too much - for instance to accommodate misguided fiscal policies, to deal with structural imbalances, or to square continuously the hypothetical circles of stability, growth and full employment - then it will inevitably fall short. If in the process of trying it loses sight of its basic responsibility for price stability, a matter that is within the range of its influence, then those other goals will be beyond its reach.
"Back in the 1950s, after the Federal Reserve finally regained its operational independence, it decided to confine its open market operations almost entirely to the short-term money markets - the so-called "bills only doctrine". We can't go back to that - we can't go home again to the simpler days of the 1950s and 1960s. Markets and institutions are much larger, far more complex. They have also proved to be more fragile, potentially subject to large, destabilizing swings in behavior. The rise of shadow banking, the relative decline of regulated commercial banks, the rapid innovation of new instruments have all challenged both central banks and other regulatory authorities.
"But one simple logic remains. It is, I think, reinforced by these developments. The basic responsibility of a central bank is to maintain reasonable price stability - and by extension that means it must take account of the stability of financial markets generally. In my judgment, those functions are complimentary and they should be doable.
"With or without a numerical target, the broad responsibility for price stability over time does not in any way imply an inability to conduct ordinary counter-cyclical policies. Indeed, in my judgment confidence in the ability and commitment of the Federal Reserve or any central bank to maintain price stability over time is precisely what makes it possible to act aggressively in supplying liquidity in recession or when the economy is in a prolonged period of growth well below potential.
"Credibility is an enormous asset. Once earned, it must not be frittered away by yielding to the notion that a 'little inflation right now' is a good thing to release animal spirits and to pep up investment. The implicit assumption behind the siren call must be that the inflation rate can be manipulated to reach economic objectives - up today, maybe a little more tomorrow, and then pulled back on command. But all experience amply demonstrates that inflation, when fairly and deliberately started, is hard to control and reverse. Credibility is lost.
"I have long argued that central bank concern for stability must range beyond prices for goods and services to the stability and strength of financial markets and institutions generally. I am afraid we collectively lost sight of the importance of banks and markets robustly able to maintain efficient and orderly functioning in time of stress. Nor has market discipline alone restrained episodes of unsustainable exuberance before the point of crisis. Too often, we were victims of theorizing that markets and institutions could and would take care of themselves.
"My concerns in that respect and their relevance to central banking and the organization of regulatory authority, were more fully expressed in a speech to this Club several years ago. Congress was then beginning to consider reform legislation. It was recognized that regulatory agencies, perhaps most specifically the Federal Reserve, had exhibited a certain laxity and ineffectiveness in the period leading up to the financial breakdown, particularly with respect to the mortgage market...
"The erosion of confidence and trust in the financial world, in the financial authorities that oversee it, and in government generally is palpable. That can't be healthy for markets or for the regulatory community. It surely can't be healthy for the world's greatest democracy, now challenged in its role of political and economic leadership..."