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3 CREDIT BUBBLE
BULLETIN Desperation in
Europe Commentary and weekly watch
by Doug Noland
Having wrapped up my working
holiday last week, my end-of-week writing schedule
should now return to normal. It's certainly been
an eventful few weeks. The European debt crisis,
again, began to spiral out of control.
Policymakers were, once again, forced into
desperate measures. Buffeted by countervailing
forces, global risk markets have bounced between
crisis-induced de-risking/de-leveraging and policy
intervention-driven speculative excess.
And
as systemic stress escalates the markets anxiously
anticipate even more powerful policy responses.
The precarious "risk on, risk off" global market
trading dynamic has become only more overbearing.
More specifically, global
risk markets rallied significantly after
Germany's capitulation at the
latest European summit. After stating rather
unequivocally that there was a line that would not
be crossed ("as long as I live"), Chancellor
Angela Merkel was seen as buckling under the
pressure.
The Germans gave into the
demands (to some, "blackmail") of the contingent
from Italy, Spain and France, as the European
powerbase lurched southward. And if Merkel was
willing to bend on European Union bailout
oversight and emergency lending directly to
Spanish banks, surely she would eventually
capitulate on eurobonds, EU system-wide deposit
guarantees and other forms of debt
"mutualization". Those believing that the Germans
would have no alternative than to eventually
backstop troubled eurozone debt issuers were
emboldened - at least momentarily.
Merkel was pilloried at home
- by the press, by her political opposition and
even within her own governing coalition. German
public opinion is clearly hardening; the German
constitutional court is preparing .... And while
it might appear that the June 28/29 summit
provided an inflection point for a more pragmatic
- and decidedly less principled - German position,
one could also envisage a scenario where such
public embarrassment engenders a tougher German
stance. After dropping to 6.11% post-summit,
Spanish 10-year yields traded back to almost 6.95%
on Friday. For the week, Spain's 10-year yields
jumped 62 basis points (bps) and Italy's rose 20
bps (to 6.01%).
In the (fleeting) post-summit
euphoria, the euro rallied from about 1.24 to
almost 1.27 against the dollar. The euro ended the
week at 1.2291, trading intraday below the June 1
trading low (1.2288). Considering the large short
position, the euro bounce was notably
unimpressive. Indeed, I view euro weakness as
confirmation of the unfolding bearish thesis.
The
bullish contingent would like to view German
policy accommodation as the beginning of the end
to the European debt crisis. I (and others)
instead see an escalating credit crisis that has
now irreparably afflicted the "core" of the
European system. It is at this point wishful
thinking to believe that the Germans - even if
they were willing to sacrifice their nation's
creditworthiness to backstop eurozone debt -
retain the capacity to sustain market confidence
in trillions of Spanish and Italian sovereign
debt, local government obligations and banking
system liabilities.
Policymakers will, as we've
witnessed again recently from European politicians
and central bankers, respond to heightened
systemic stress by ratcheting up their responses.
Yet, and also no surprise, these increasingly
desperate measures will have depleted and fleeting
effects - and really tend only to heighten market
instability. The big unknown remains the timing of
when market confidence in the capacity of policy
measures to incite market rallies is finally
depleted. Without this carrot, I expect we'll be
facing an altered global market environment.
The
structure of today's marketplace (especially with
respect to the proliferation of hedging and
derivative trading strategies) is conducive to
short squeezes. This is compounded by the policy
environment backdrop whereby market players
(sophisticated and otherwise) fully recognize that
policymakers are determined to backstop the
markets. This incentivizes speculation and, I
would argue, has nurtured bubble dynamics.
Understandably, trumpeting
global market resilience in the face of European
debt tumult and slowing global growth has become
common. I continue to fear that the confluence of
complacency, policy impotence, and endemic global
market speculative excess creates unappreciated
systemic fragilities.
Extraordinarily divergent
macro views have solidified. Some see the makings
for a new secular bull market. I instead see an
increasingly susceptible global credit bubble and
attendant historic financial mania. A critical
facet of this thesis remains that policymakers
will go to incredible lengths to sustain credit,
financial and economic booms. And while this
guarantees difficulty in assessing the timing of
when catastrophe might strike - it seemingly
ensures such an outcome. With unsettled markets
only adding to confusion, I thought it appropriate
this week to touch upon credit theory to try to
bring a little clarity to the muddled macro
backdrop - trying to stay focused on the big
picture.
During the halcyon upside of
the credit cycle, ever increasing quantities of
credit disburse purchasing power throughout
financial and economic systems. The credit-induced
increase in spending supports income growth,
consumption, corporate profits, investment,
government receipts/expenditures and economic
output. Asset inflation is seen as fundamentally
driven and, furthermore, as confirmation of the
bullish viewpoint. One can say that credit growth
is self-reinforcing - or "recursive." Importantly,
the upside of credit booms ensures seemingly
positive "fundamentals" that validate the system's
financial asset price structures and, more
generally, the expansive credit and financial
infrastructure.
The credit boom ensures
notions of economic "miracles", "new eras," and
"new paradigms". Policymakers are generally seen
as astute; economic doctrine as advanced and
enlightened. The inflationary bias associated with
the credit cycle's upside provides policymakers
great flexibility - and seemingly ensures policy
effectiveness.
And especially after a few
episodes where policy responses free the system
from the jaws of crisis, players throughout the
markets and economy (not to mention the general
public) come to believe in the capacity of
policymakers to avoid trouble and sustain the
boom. The social mood is one of general optimism,
cooperation and cohesion. The pie is perceived to
be getting bigger, and most are for the most part
satisfied that they're enjoying their fair share.
And, of course, "bull markets create genius"."
The
unavoidable may be avoided for years, yet the
brutality of a credit cycle's downside in the end
will be commensurate with the duration and scope
of boom-time excesses. And the changed credit
environment changes so many things.
The
maladjusted economic structure will eventually
give way, ushering in a cycle of deteriorating
fundamentals - including stagnant household
incomes, faltering profits and deteriorating
government finances. The pie will not only be
shrinking, but most will come to see a fortunate
few unfairly taking an ever increasing share to
the detriment of everyone else. The system will be
viewed as inequitable, unjust and flat out broken.
The social mood turns sour, as most incomes
stagnate (or worse) and perceived financial wealth
withers. Faith in institutions will wane.
Post-bubble policymakers will invariably be viewed
as inept. Optimism is supplanted by pessimism. As
always, wrenching bear markets create disdain and
hostility.
Credit's downside, along with
accompanying bear markets, over time instills
wreaking ball havoc upon the credit structure. In
the final analysis, credit is everything and
always about confidence. During the credit
expansion, constructive fundamentals and general
optimism bolster the perception that credit is
sound and that most credit instruments will be
vehicles of wealth generation. As a credit bust
ensues and the economic and asset price backdrop
deteriorates, ever-increasing swaths of credit
instruments are viewed as impaired or even
dubious. The entire credit and financial
structure, having grown to incredible stature
during the boom, turns brittle and unstable - with
trouble generally starting out on the "periphery"
before eventually rotting away at the "core".
Policymakers will not accept
defeat without one hell of a fight. Dreadful
policy errors will be repeated and compounded.
Government officials will go to increasing
inflationary lengths to bolster incomes and
economic output, support asset markets, and
stimulate credit growth. Such measures typically
enjoy initial success, though such a policy course
will invariably lead to an expanding governmental
role in the economy and an interventionist role in
the credit and asset markets. Too be sure,
increasingly unsound finance will be mispriced and
poorly allocated.
Stubborn refusal to admit
policy mistakes along with increasing desperation
ensure things will only get worse. Over time, it
all regresses into a perilous confidence game.
Government intervention and monetary stimulus
inflate confidence for awhile, although such
actions only weaken the underpinnings of the
credit structure.
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