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     Sep 3, '13

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Weak links
Commentary and weekly watch by Doug Noland

It was another week of acutely unsettled emerging markets (EM). India's rupee (down 3.6% for the week) and Turkey's lira (down 2.5%) traded to record lows on Wednesday. Indonesia's rupiah traded to the lowest level since April 2009 (down 1.1%). The Mexican peso fell 3.2% and Brazilian real declined 1.5%, while many Eastern European currencies played downside catch-up. The Polish zloty declined 2.2%, the Hungarian forint 2.2%, the Czech koruna 1.5% and the Romanian leu 1.3%.

Especially early in the week, EM equities and bond markets were suffering the apparent effects of increasingly destabilizing

outflows. Market tumult provoked a flurry of policy measures. Brazil raised rates. Indonesia boosted rates and extended a currency swap arrangement with the Bank of Japan (BOJ). India's central bank implemented a currency swap arrangement with the country's major energy companies, in a plan that would provide dollar liquidity to finance the rapidly escalating cost of energy imports. Policy effects seemed fleeting at best.

An unstable market backdrop compounded by desperate policy measures definitely made for some wild currency market volatility, notably for the Indian rupee and Indonesian rupiah. Meanwhile, the week provided added confirmation that the emerging market complex has commenced the self-reinforcing downside of an historic credit cycle. Sinking currencies coupled with surging crude prices ensures that already rising inflationary pressures will intensify. This is especially an issue for India, Indonesia, Brazil, Turkey and Russia. And rising inflation and resulting bond market losses will only work to exacerbate ''hot money'' and investment outflows.

Weak markets, robust ''hot money'' outflows, rising inflation and higher policy rates all point to a consequential tightening of EM financial conditions. I have posited that major bubble economies and financial systems are acutely vulnerable to any tightening of financial conditions. And while the marketplace is coming to better appreciate EM fragilities, the consensus view remains that the situation is quite manageable. Few expect EM to have much impact on US markets or the American economic recovery.

EM instability has increased the relative appeal of US securities markets, especially from the perspective of the hedge fund community and the greater ''global pool of speculative finance'' more generally. US equities have benefited from the rotation away from both EM and Treasurys. There is certainly no doubt that highly speculative, over-liquefied markets will chase outperforming asset classes. And a resilient equities market has both captured the imagination and worked to embolden the bullish mindset.

I would tend to view the popular consensus view as superficial and complacent. While US stocks have been ''resilient'', I would warn against disregarding prospects for a tightening of financial conditions. From the vantage point of my analytical framework, I have seen sufficient confirmation of the bursting EM bubble thesis. It's now time to begin thinking forward to potential consequences. What are potential transmission mechanisms that could link the unfolding EM crisis to US markets and our economy? Where are possible weak links?

Generally, I view the global economy and financial ''system'' as anything but robust. Global economic maladjustment and imbalances are unprecedented. A multi-decade credit boom - culminated by post-'08 crisis ''terminal phase'' excess in China and EM - has left a legacy of acute fragility. Europe remains susceptible. For starters, analysts have been slow to recognize the direct impact the EM crisis will have upon global growth and corporate profits.

Unprecedented fiscal and monetary stimulus - now years of ultra-loose ''money'' - have stoked renewed US asset price inflation/bubbles. Still, the structurally challenged real economy refuses to gather a head of steam. Inflated global securities markets have become addicted to government guarantees and liquidity backstops, not to mention the Federal Reserve and BOJ's $160 billion monthly QE/''money printing''. From the global government finance bubble perspective, there have been a multitude of excesses with associated fragilities to less accommodative market environments. I see deeply systemic fragilities.

There would appear to be myriad weak links. I would argue that the global economy has never been as dependent upon the financial markets - as distorted markets have become hopelessly speculative and unsound. Fragile economic and financial systems have never been as vulnerable to a meaningful tightening of financial conditions. The bullish retort would be that central bankers remain on the case and have things well under control. That said, I believe the global leveraged speculating community is today a primary weak link and potential transmission mechanism for contagious EM disorder to afflict the developed world, including the US.

The hedge fund community has struggled for performance in recent years. Globally, there is way too much speculative finance chasing way too few attractive opportunities. So it's degenerated into a rather barbarous high-stakes enterprise of speculation. Years of global imbalances coupled with trillions of dollars in quantitative easing (QE) and central bank purchases have been instrumental in the ballooning pool of speculative finance and the dysfunctional ''crowded trade'' market phenomenon. The collapse of interest rates has been instrumental in driving ''money'' to the hedge funds, especially from the pension fund complex requiring 8-9% annual returns. So, despite weak performance, the hedge fund industry has continued to enjoy inflows and record assets.

This year commenced with great hope that the hedge fund industry would finally turn the corner and put up some big numbers. Massive QE seemed to guarantee inflating global risk asset markets. The Draghi Plan of the European Central Bank appeared to ensure Europe would finally emerge from crisis. And surging stocks and home prices were seen finally propelling the US economic recovery to launch speed. Global markets got off to a strong start - but it wasn't too long before the global market instability wrecking ball started chipping away at hedge fund performance.

Gold and commodities weakness hurt performance, especially in the second quarter, as many funds were caught on the wrong side of a faltering ''global reflation trade.'' EM currencies and equities also became minefields. Then (in spite of massive QE) global bond yields began to shoot higher, catching even the most adroit market operators flatfooted. June was a particularly painful month, as EM and bond selling fueled huge outflows from international and fixed-income funds. Latent liquidity issues surfaced in various exchange-traded fund products, which induced a surprising tightening of market conditions in US mortgage and municipal finance. At the same time, resilient US equities ensured the performance-chasing speculators crowded deeper into our stock market.

A curious, perhaps quite important, dynamic developed. As the hedge funds and others increased exposure to outperforming US stocks, the resulting resilience in our equities market bolstered the bullish view of the resiliency of the US economy more generally. I would argue, however, that this dynamic makes certain that market participants will overlook significant mounting risks of a tightening of finance both globally and, believe it or not, even here in the US.

The overwhelming consensus view holds that the Fed (along with global central banks) controls financial conditions. Global markets have been keenly sensitive to taper talk, although most believe the Fed will continue to ensure ample liquidity - that the Fed, as Federal Reserve chairman Ben Bernanke stated, would ''push back'' against a tightening of market liquidity.

And while central banks clearly play an instrumental role, I view the leveraged speculating community as customarily the marginal player in determining financial conditions. When risk is being embraced and leveraged positions are being expanded, this is constructive for marketplace liquidity and a loosening of financial conditions more broadly. When, instead, risk aversion and de-leveraging are in play, market liquidity suffers and financial conditions tighten. This dynamic has been only somewhat mitigated by ongoing huge QE.

The markets' fixation with tapering has distracted attention away from potentially far-reaching market developments. Has a multi-decade bond bubble about run its course? Are global central banks finally losing control of market yields? After unprecedented inflows, does the abrupt reversal of flows away from EM (and resulting selling of international reserves by EM central banks) mark a major inflection point for Treasurys and global bonds more generally? What are market ramifications for an abrupt reversal of flows out of the "leveraged speculating community"?

I think I can make a decent case that over recent years the US (and global) bond market succumbed to ''terminal phase'' excess. Fed policies ensured trillions of Treasury, municipal bonds, mortgage-backed securities and corporate debt were issued at artificially depressed yields (highly inflated prices). This great mispricing is now coming back to trouble the system. Investors are being hit with losses and a self-reinforcing re-pricing dynamic is seeing flows begin to exit the sector. This reversal of flows coupled with EM central bank selling has significantly altered the risk profile of maintaining leveraged speculative positions in long-term fixed income instruments.

Fed QE notwithstanding, I believe the market backdrop today implies an important tightening of financial conditions going forward. Policy measures - including boosting QE - do (once again) have the potential to delay this tightening, although with the cost of only exacerbating the wide gulf that has developed between inflated global securities prices and deteriorating economic prospects.

If financial conditions are indeed tightening globally, I would expect the typical ''periphery to core'' dynamic to ensure a jump of EM stress to the more fragile peripheral developed markets. Europe and the euro initially benefited from the flight out of EM, although last week's poor market performance was noteworthy. The euro dropped 1.2% (1.75% vs. the yen), its worst performance in weeks. Germany's DAX index was hit for 3.7%, France fell 3.3%, Spain sank 4.6% and Italian stocks dropped 3.8%.

Perhaps indicating hedge fund de-risking/de-leveraging, European sovereign bond yield spreads (to bunds) widened last week. French yields widened 8 basis points (bps) versus bunds yields to a one-month high 61 bps. Italian and Spanish bond spreads to bunds widened a notable 15 and 16 bps. And at the troubled eurozone periphery, Portugal saw its 10-year yield jump 16 bps to 6.59% and Greece yields rose 24 bps to 10.02%. I suspect European Central Bank president Mario Draghi's dramatic year-ago move to backstop European bonds enticed the leveraged speculators back into higher-yielding eurozone bonds.

Here in the United States, stocks were under some pressure while Treasurys generally held their own. Risk spreads widened somewhat. Interestingly, the VIX index jumped to the highest level since late-June. Benchmark MBS spreads were little changed. It is worth noting that, at 4.51%, benchmark 30-year mortgage borrowing rates have jumped 116 bps points from May lows. The mortgage Bankers Association weekly refi application index last week dropped to the lowest level since February (and near the weakest level since 2009). Higher borrowing costs will now throw some cold water on real estate markets. And there will be further economic ramifications for the end to a several-year period of homeowners improving their monthly cashflows by refinancing into low-cost mortgages.

Corporate debt issuance has slowed markedly, although issuance is expected to pick up in September. Last week saw investment-grade and junk spreads widen 5 bps and 14 bps. Similar to equities, high-yield corporate debt has benefited at the expense of EM and Treasurys. I would expect junk bonds and leveraged finance more generally to be susceptible to equity market weakness and de-risking more generally.

According to Friday's Bond Buyer, ''The plunge in long-term municipal bond volume for 2013 continued as issuers in August floated 37.7% less than they did over the same period in 2012 ... municipalities issued $20.9 billion last month in 746 deals, against $33.5 billion in 1,066 issues in August 2012.'' An index of long-term bond yields ended the week at 4.07%, up about 150 bps from early May to the highest level since May 2011.

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