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3 CREDIT BUBBLE
BULLETIN Crowded (dangerous)
trades Commentary and weekly
watch by Doug Noland
It was, to say the
least, another interesting week. JPMorgan restated
its first quarter earnings, as the company's
"London Whale" synthetic derivative loss jumped to
US$5.8 billion. Another city in California can't
pay its bills and readies for bankruptcy. China
reported second quarter growth at 7.6%, a
three-year low, while articles abound questioning
the veracity of Chinese data.
Moody's
downgraded Italy's sovereign debt rating two
notches to not much better than junk. Apparently,
Silvio Berlusconi is preparing for another run at
the Italian presidency, as the competent Mario
Monti states he's not interested. Spain's
fledgling President
Rajoy announced yet another austerity plan, this
time hoping to trim a (stubbornly) huge budget
deficit by $80 billion.
From my
perspective, the most meaningful of last week's
data was Friday's report from the European Central
Bank (ECB) showing that Spanish bank borrowings
had reached a record 337 billion euros (US$411
billion), up almost 50 billion euros during June.
Spanish institutions have now increased ECB
borrowings by 204 billion euro in only five
months. There's no mystery surrounding President
Rajoy's snappy acquiescence to European Union
demands for additional painful deficit-cutting
measures. Spain's banking system is suffering a
run on deposits and liquidity. The euro traded to
two-year lows Friday morning, before rallying
somewhat to close out another losing week.
From Friday's Wall Street Journal "Heard
on the Street" column (Simon Nixon):
Feeling more relaxed about the euro
crisis since last month's summit? Think again.
The risk of a euro-zone breakup may actually be
rising rather than falling, according to Bank of
America Merrill Lynch strategists David Woo and
Athanasios Vamvakidis. Using game theory to
consider how the situation might evolve, they
believe the crisis will boil down to a game of
bluff between Italy and Germany in which neither
country has an incentive to back down. That
doesn't mean this would be the best outcome for
either side; in game theory, the most likely
outcome isn't always what economists call
"Pareto optimal", one that will bring maximum
benefit to all players. Instead, the "Nash
equilibrium" for the euro zone - the situation
in which no player has an incentive to change
strategy because to do so unilaterally would
leave them worse off - is that Italy refuses to
undertake the overhauls needed to enable its
economy to grow and Germany refuses to provide
the bailouts to persuade it to
stay."
From Wikipedia:
It is commonly accepted that
outcomes that are not Pareto efficient are to be
avoided, and therefore Pareto efficiency is an
important criterion for evaluating economic
systems and public policies. If economic
allocation in any system is not Pareto
efficient, there is potential for a Pareto
improvement - an increase in Pareto efficiency:
through reallocation, improvements can be made
to at least one participant's well-being without
reducing any other participant's well-being. ...
In practice, ensuring that nobody is
disadvantaged by a change aimed at achieving
Pareto efficiency may require compensation of
one or more parties. For instance, if a change
in economic policy eliminates a monopoly and
that market subsequently becomes competitive and
more efficient, the monopolist will be made
worse off ... This means the monopolist can be
compensated for its loss while still leaving a
net gain for others in the economy, a Pareto
improvement. In real-world practice, such
compensations have unintended consequences. They
can lead to incentive distortions over time as
agents anticipate such compensations and change
their actions accordingly.
I'd prefer
that this analysis was not too technical, but the
"Pareto optimal" and "Nash equilibrium" concepts -
and game theory more generally - are critical for
analyzing both the unfolding European crisis and
the extraordinary global macro credit environment.
Besides, it doesn't hurt to ponder whether
reasonable explanations exist that help explain
why post-bubble policymakers are generally cast as
such nincompoops.
I dove deeper into
credit theory last week, attempting to illuminate
how the nature of policymaking/politics can change
profoundly depending upon the evolutionary phase
of the credit cycle. In particular, the idea of
European political cooperation and monetary
integration resonated during the potent upside of
the global credit boom. Credit, economic output
and asset prices were expanding - the economic pie
was seen as growing ever larger. Optimism and
extrapolation reigned supreme - as they do.
In game theory terms, players were willing
to compromise and, in some cases, "reallocate".
Politicians and central bankers recognized that
individual country benefits - and gains to the
integrated system overall - would greatly outweigh
the associated costs. Cooperation, after all, was
certain to spur system-wide efficiencies and
enhanced economic wealth. Europe's wealthier
countries were willing to subsidize the poorer,
confident of the overwhelming benefits to
economic, financial and monetary integration.
China, Asia and others were more than willing to
monetize ongoing US trade deficits, believing the
overall benefits to growth and prosperity
outweighed gradual devaluation of their dollar
holdings.
But the downside of the credit
cycle radically alters rules of the game. Over
time, reality sinks in that the previous
prosperity was in fact an unsustainable boom-time
phenomenon. The downside of the credit cycle
ensures faltering asset prices, deflating
household net worth and financial sector
deficiencies, along with the revelation of
problematic economic imbalances and maladjustment.
It's not long into the bust before many
see themselves as losers - and to have lost
unjustly at the hands of an unfair system. The
growing ranks of losers become an increasingly
powerful political force.
The pie -
recognized as having been previously inflated by
excess and policy largess - is seen as vulnerable
and shrinking, much to the dismay of the general
public whose expectations were so inflated during
the previous bubble. The credit cycle's downside
ushers in a period where individual players become
acutely focused on ensuring that they get the
largest possible share of what they view as a
contracting pie. The backdrop no longer
incentivizes cooperation, cohesion and
integration.
As has been demonstrated by
political stalemates in Brussels, as well as in
Washington, "Nash equilibrium" dynamics prevail,
"the situation in which no player has an incentive
to change strategy because to do so unilaterally
would leave them worse off".
But let's not
limit game theory analysis primarily to Europe.
And, importantly, the upside of the global credit
bubble has not yet fully run its course. So, from
a more global macro point of view, a "Pareto
optimality" mindset still holds sway. Global
central bankers remain predominantly of the view
that the overall benefits from cooperation,
monetization and currency devaluation outweigh the
costs. Ultra-low rates compensate borrowers at the
expense of savers, a cost policymakers view as
easily outweighed by the systemic benefits of
sustained global credit expansion.
And,
astutely, from Wikipedia above:
In real-world practice, such
['Pareto optimal'] compensations have unintended
consequences. They can lead to incentive
distortions over time as agents anticipate such
compensations and change their actions
accordingly.
"Incentive
distortions" don't get deserved attention. The
conventional view holds that inflation poses the
predominant risk emanating from loose monetary
policy. Yet with Chinese and Asian mega-factories
seemingly capable of forever saturating the world
with inexpensive goods, central bankers and
analysts these days easily dismiss inflationary
risks. Essentially free money is, basically,
costless, or so the thinking goes. And if it all
seems too good to be true, it's because no one
wants to delve into the true costs associated with
monetary policy incentives having so maligned
global financial markets.
Previous Credit
Bubble Bulletins have focused on the dysfunctional
nature of the "risk on, risk off" - Roro - market
trading dynamic. Instead of a fleeting fad, Roro
has become only more deeply entrenched - seemingly
becoming a permanent fixture. Arguably, the market
backdrop has regressed only further into a casino
of wagers either on or against the capacity of
policy responses to incite market rallies.
Risk markets have become only more highly
correlated - and the bets only more fixated on red
or black (or, more accurately, the flashing red or
green from the Bloomberg screen). And the two
biggest outgrowths from years of monetary policy
incentives - the mammoth leveraged speculating
community and global derivatives markets - are
struggling to perform as expected. This comes as
no surprise.
An era of "incentive
distortions" - years of loose money and decades
now of "activist" central bank market intervention
- has severely distorted the underlying structure
of credit, financial market, and economic systems.
Beginning back in the early 1990s, the Alan
Greenspan Federal Reserve actively "reallocated"
financial returns to the impaired banking system
by slashing short-term borrowing costs and
orchestrating a steep yield curve ("free money"
from borrowing short and holding longer-term debt
instruments). Intervening in the markets to boost
depleted bank capital was seen as providing
extraordinary system benefits.
Little
attention was thus paid to the fact that this also
incentivized leveraged speculation. And the hedge
fund industry hasn't looked back since, with
assets exploding from about $50 billion to surpass
$2.1 trillion. And with the Fed and the cadre of
global central banks guaranteeing "liquid and
continuous" markets, the derivatives and risk
insurance marketplaces exploded to unfathomable
hundreds and hundreds of trillions. The larger
these bubbles and associated risks inflated, the
more confident the speculator community became
that more aggressive policy measures and market
interventions would be forthcoming.
I
would today argue there is a momentous
unappreciated cost to central bankers'
"reallocations" and "incentive distortions:
they've nurtured one massive, and now hopelessly
unwieldy, "crowded trade" throughout global risk
markets. As seasoned traders appreciate, once a
trade becomes "crowded" the nature of how a trade
- how a market - performs tends to turn highly
unpredictable, erratic and, in the end,
unsatisfying. Over time, fundamental developments
are overshadowed by the brute force of market
technicals.
For example, "crowded" short
positions will tend to "melt-up" into dramatic
short squeezes before eventually collapsing.
Crowded longs tend to turn highly speculative, yet
inevitably susceptible to air-pockets and abrupt
downdrafts. Locate a "crowded trade" and you've
found a captivating place where it's easy to lose
money. In general, crowded trades fuel
speculation, unpredictability, and bubble dynamics
- along with a lot of frustration and eventual
disenchantment.
Global central bankers
have ensured that way too much money now chases
limited global risk asset market returns
(contemporary prevailing inflation). With global
short-term rates pushed near zero, hundreds of
billions have flooded into more speculative
instruments and ventures, certainly including the
global hedge fund community. Not surprisingly,
funds have struggled with performance.
After a poor 2011, scores of funds have
crowded into similar trading strategies and are
these days under intense pressure to make money.
Many are desperate not to miss a tradable market
trend, while at the same time suffering from an
unusually low tolerance for losses. Funds,
careers, businesses and dreams are at stake - and
the "tape" shows it.
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