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2 CREDIT BUBBLE
BULLETIN Jackson Hole and 'Risk
3' Commentary and weekly watch
by Doug Noland
Bloomberg's Mark Deen
wrote on August 30: "Yale University professor
Stephen Roach said Federal Reserve chairman Ben S
Bernanke shouldn't be given a third term because
of his role in managing the US economy before the
financial crisis. 'I think Bernanke tried his best
post-crisis, but he's part of the problem
pre-crisis,' Roach said ... 'He and [former Fed
chairman] Alan Greenspan condoned asset bubbles at
a time the economy
needed more discipline.' ...
For Roach, Bernanke's work to calm markets
following the financial crisis doesn't mean his
part in inflating asset bubbles in previous years
should be overlooked. 'To reward him for
post-crisis, very valiant efforts of public
service completely overlooks the role he played in
getting the US asset markets and an
asset-dependent economy into this mess in the
first place ... "
Chairman Bernanke titled
his 2012 presentation at the Fed's Jackson Hole
summer symposium "Monetary Policy since the Onset
of the Crisis". His review begins with the Fed's
initial response to the unfolding mortgage crisis
in August 2007. The paper then details five years
of policy measures, with section headings "Balance
Sheet Tools", "Communication Tools", "Economic
Prospects", and "Making Policy with Nontraditional
Tools: A Cost-Benefit Framework."
Bernanke
concludes with coded dovish messages, including
"grave concern" that "high levels of unemployment
will wreak structural damage" - after earlier
signaling support for the Draghi Plan - propounded
by European Central Bank president Mario Draghi
("recent policy proposals in Europe have been
quite constructive in my view, and I urge our
European colleagues to press ahead ... ").
As noted above by the astute Stephen
Roach, Bernanke played an instrumental
intellectual role in crafting policy with then
chairman Greenspan that fatefully nurtured the
mortgage finance bubble. In arguably history's
greatest monetary policy misadventure, the
Greenspan/Bernanke Fed purposely ignored the
unfolding bubble, choosing instead to commit the
Federal Reserve to aggressive post-bubble "mopping
up" strategies.
Five years into the
crisis, the extent of required "mopping up"
remains an unfolding saga that will be analyzed
and debated for decades to come. To be sure, the
Federal Reserve's framework for monetary policy
cost-benefit analysis during the post-technology
bubble reflationary period (2002-2007) was an
abject failure. Most of us strive to learn from
our big mistakes.
Chairman Bernanke, not
unsurprisingly, made it clear in Jackson Hole last
week that he is prepared to move further into the
uncharted waters of "non-traditional" monetary
tools. His review came out on the side of benefits
outweighing "manageable" costs, although perhaps
to placate the hawks he cautioned, "The hurdle for
using nontraditional policies should be higher
than for traditional policies. At the same time,
the costs of nontraditional policies, when
considered carefully, appear manageable, implying
that we should not rule out the further use of
such policies if economic conditions warrant."
Before delving into his cost-benefit
framework, it is worth mentioning that the word
"bubble" is nowhere to be found in Bernanke's
paper. I strongly argue that the issue of whether
the Fed is once again accommodating a credit
("government finance") bubble is today's
prevailing - potentially catastrophic - policy
risk. The possible role that non-traditional
policy tools might be playing in nurturing bubble
dynamics should be the focal point of any
cost-benefit analysis related to the Fed's
experimental policymaking endeavor. Regrettably,
it's completely disregarded - hear no evil, speak
no evil, and see no evil.
Bernanke
highlights four potential costs of large-scale
asset purchases (LSAP): 1) Impairment to the
functioning of securities markets ("Fed dominance"
"degrading liquidity and discovery"); 2)
substantial Fed balance sheet expansion could
reduce public confidence (ie exit strategy and
inflation expectation issues); 3) risks to
financial stability (ie "could induce imprudent
reach for yield by some investors"); 4) "The
possibility that the Federal Reserve could incur
financial losses should interest rates rise to an
unexpected extent."
I take exception with
those calling Bernanke's presentation "balanced".
He again misjudges and woefully underestimates
risk. My analytical focus is directed at Risk #3,
with the view that the Bernanke Fed is again
disregarding myriad risks to financial stability
associated with marketplace interventions and
manipulations.
Indeed, it would appear
that risks to financial stability are escalating
in concert with the escalation in the course of
global monetary policy measures. Bernanke's
"imprudent reach for yield by some" contrasts with
my fear of the greatest financial bubble in the
history of mankind.
From Bernanke's paper:
Of course, one objective of both
traditional and nontraditional policy during
recoveries is to promote a return to productive
risk-taking; as always, the goal is to strike
the appropriate balance. Moreover, a stronger
recovery is itself clearly helpful for financial
stability. In assessing this risk, it is
important to note that the Federal Reserve, both
on its own and in collaboration with other
members of the Financial Stability Oversight
Council, has substantially expanded its
monitoring of the financial system and modified
its supervisory approach to take a more systemic
perspective. We have seen little evidence thus
far of unsafe buildups of risk or leverage, but
we will continue both our careful oversight and
the implementation of financial regulatory
reforms aimed at reducing systemic
risk.
I will first note that the
Greenspan Federal Reserve was caught completely
off-guard by the market excesses that their
policies had nurtured back during the (then)
aggressive 1992/93 reflation period. It is worth
noting that the hedge fund community has expanded
about 20-fold since, to a record US$2.1 trillion.
Global derivatives markets have mushroomed to
hundreds of trillions. Importantly, derivatives
markets as well as the global "leveraged
speculating community" have continued to grow
post-2008 crisis - only further bolstered by
aggressive policy regimes.
The failure of
JPMorgan's "whale" derivatives trades to garner
the attention of regulators (prior to their
disclosure) does not inspire confidence that the
Federal Reserve can satisfactorily gauge the
amount of leverage or other risks that have
accumulated in the amorphous world of global
securities and derivatives markets.
That
non-traditional monetary policy tools today work
similarly to how traditional measures functioned
historically is one of the great policy myths of
this period. There remains this notion, again
furthered by Bernanke, that some quantity of
quantitative easing (additional debt
purchases/liquidity creation/Fed balance sheet
growth) today would equate to, say, a 25 basis
points (bps) point cut in the Fed funds rate 25
years ago. Yet the entire monetary policy transfer
mechanism has been radically altered, foremost by
the transformation of system credit expansion from
primarily bank-loan driven to one dominated by
marketable debt and myriad risk intermediation
channels.
Traditionally, central bank
stimulus would entail adding reserves into the
banking system to effectively reduce the cost of
funds, thereby incentivizing additional bank
lending. Today, Federal Reserve monetary stimulus
is transmitted primarily through incentivizing
risk-taking and leveraging in the securities,
derivatives and other risk asset markets.
We now have about 20 years experience in
support of the thesis that there exists a powerful
interplay between activist central banking,
marketable debt and financial speculation. Yet the
Fed somehow seems to ensure that its analysis
avoids addressing the associated risks of an
ever-increasing Federal Reserve role in the
pricing and trading dynamics of an ever-expanding
quantity of securities, derivatives and market
speculation.
The media continue with this
focus on the timing of the Fed's announcement for
further quantitative easing (QE3). This now seems
archaic. Global central bankers, whether Draghi at
the ECB, or the Bernanke Fed, the Bank of England,
the Swiss National Bank (SNB), or others, now
actively pursue the power of "open-ended" monetary
and market support/intervention. No quantification
necessary.
This escalation to
unconstrained monetary stimulus was the motivation
for last week's "Do whatever it takes!" (See Credit
Bubble Bulletin, Asia Times Online, August 28,
2012) Drs Draghi and Bernanke have done nothing
less than to signal to the marketplace that they
at any point and to any extent deemed necessary
will be there to backstop the markets.
Worries - albeit those associated with
so-called "exit strategies" or inflation risks -
have been completely overshadowed by a resolute
determination to avert another global crisis. It
may have been subtle; it's no doubt radical. The
Draghi and Bernanke "puts" have been significantly
bolstered and manifestly communicated.
Sophisticated global speculators operate knowing
central bankers are unequivocally determined to
quell so-called "tail" risk of illiquid and
faltering securities markets.
I'm
completely aware that this line of analysis would
today be considered by most to be wacko
lunatic-fringe stuff. I am, as well, confident
that in, say, five or so years' time analysts will
look back at this period and claim it was obvious
the Fed policy had been fueling a bubble in
Treasury and other securities markets. We've seen
it all before.
Yet with markets rallying
strongly over the past month and with heady 2012
gains only mounting, the bullish spirit has
triumphed. Talk has turned to a new secular bull
market, along with visions of the "American
Decade" (and century!). If only Washington would
get to work on the fiscal issue, economic
fundamentals would be sound - or so the thinking
goes.
I'm the first to admit that it's
easy to dismiss the view that only a month or so
ago rapidly escalating European debt tumult was at
the brink of unleashing the forces of global
financial and economic crisis. The path from
illiquid Spanish and Italian debt markets and a
crisis of confidence in the euro to a more
globalized panic was not so difficult to discern:
illiquid markets, de-risking/de-leveraging
dynamics, capital flight, systemic banking
stability issues, derivative and counterparty
concerns, hedge fund problems and a resulting
abrupt tightening of global financial conditions.
Draghi surely believed he had no alternative than
to go radical - and now Bernanke and others are as
well ready to do whatever it takes.
Let's
return to Risk #3. Global markets have rallied
strongly. Those bearishly positioned have been
mauled. Risk hedges have been unwound. The
speculator community has positioned bullishly
around the globe to profit from the latest
policy-induced bout of "risk on." Those betting on
the power of the policymaker market backstop have
been rewarded and emboldened.
What if it
doesn't work? What if policymakers have prodded
everyone to one side of the boat - and then it
tips? Is policymaking bolstering financial
stability or, rather, exacerbating instability? It
is now generally accepted that additional monetary
stimulus would have little economic impact. Yet
moving toward aggressive "open-ended" market
interventions is, understandably, having a major
impact on marketplace dynamics. Is financial
stability again being unwittingly subverted?
Monetary policy will not resolve deep
structural financial and economic issues in Europe
- nor in the US, Japan, China or elsewhere around
the world, for that matter. History informs us it
will likely make things worse. With focus on
Jackson Hole, it was easy on Friday to miss the
widening hole in the Spanish bond market.
Spain's 10-year yields jumped 27 bps to
6.81%, with yields up 45 bps for the week. Spain
credit default swap (CDS) prices jumped 21 bps
this week (eight-session rise of 62 bps) to an
almost one-month high 518 bps. Italian CDS ended
the week 12 higher to 467 bps. Curiously, precious
metals gained this week while most industrial
metals lost. Is this evidence of market players
willing to bet on policy-induced currency
devaluation, while less than convinced that
impending monetary stimulus will have much real
economic impact?
Draghi clearly has his
plan - and his wingman at the Federal Reserve.
There may be no turning back. At the same time,
the European financial, economic and political
issues may very well prove insurmountable.
Yet why would the speculator community
spend much time fretting the next round of "risk
off", not with global central bankers waiting
anxiously with bazookas fully loaded. In the end,
I suspect policymakers will regret inciting this
particular, potentially unwieldy, phase of "risk
on" market speculation and financial mania.
WEEKLY WATCH The S&P500
slipped 0.3% (up 11.9% y-t-d), and the Dow
declined 0.5% (up 7.2%). The S&P 400 Mid-Caps
added 0.1% (up 10.5%), and the small cap Russell
2000 rose 0.4% (up 9.6%). The Morgan Stanley
Cyclicals fell 1.2% (up 7.8%), and the Transports
sank 2.2% (down 0.2%). The Morgan Stanley Consumer
index added 0.2% (up 7.5%), while the Utilities
fell 1.0% (down 0.8%). The Banks were little
changed (up 19.8%), while the Broker/Dealers
increased 0.4% (down 2.5%). The Nasdaq100 slipped
0.2% (up 21.7%), while the Morgan Stanley High
Tech index declined 1.0% (up 14.8%). The
Semiconductors fell 0.7% (up 8.7%). The
InteractiveWeek Internet index declined 1.1% (up
10.1%). The Biotechs dipped 0.4% (up 34.2%). With
bullion up $46, the HUI gold index added 0.6%
(down 8.1%).
One Treasury bill rates ended
the week at 8 bps and three-month closed at 7 bps.
Two-year government yields were down 5 bps to
0.22%. Five-year T-note yields ended the week down
12 bps to 0.59%. Ten-year yields fell 14 bps to
1.55%. Long bond yields sank 13 bps to 2.67%.
Benchmark Fannie MBS yields sank 17 bps to 2.27%.
The spread between benchmark MBS and 10-year
Treasury yields narrowed 3 to 72 bps. The implied
yield on December 2013 eurodollar futures fell 6.5
bps to 0.41%. The two-year dollar swap spread was
little changed at 18 bps, and the 10-year dollar
swap spread was little changed at 11 bps.
Corporate bond spreads ended mixed. An index of
investment grade bond risk increased one to 101
bps. An index of junk bond risk declined 3 to 543
bps.
Debt issuance slowed to a trickle. I
saw no investment grade or junk issued this week.
Junk bond funds saw inflows rise to
$1.17bn (from Lipper).
I saw no
convertible debt issued.
International
dollar bond issuers included China Oilfield
$1.0bn, Trancent Holdings $600 million and
Manitoba $600 million.
Spain's 10-year
yields jumped 45 bps to 6.81% (up 177bps y-t-d).
Italian 10-yr yields rose 14 bps to 5.82% (down
121bps). German bund yields declined 2 bps to
1.33% (down 49bps), while French yields jumped 11
bps to 2.15% (down 99bps). The French to German
10-year bond spread widened 13 bps to 82 bps.
Ten-year Portuguese yields declined 3 bps to 8.98%
(down 379bps). The new Greek 10-year note yield
dropped 46 bps to 22.74%. U.K. 10-year gilt yields
fell 6 bps to 1.46% (down 51bps). Irish yields
were up 4 bps to 5.77% (down 249bps).
The
German DAX equities index was unchanged (up 18.2%
y-t-d). Spain's IBEX 35 equities index gained
another 1.5% (down 13.4%), and Italy's FTSE MIB
rose 1.5% (up 0.1%). Japanese 10-year "JGB" yields
declined one basis point to 0.79% (down 20bps).
Japan's Nikkei sank 2.5% (up 4.6%). Emerging
markets were weak. Brazil's Bovespa equities index
fell 2.3% (up %), and Mexico's Bolsa dropped 2.0%
(up 6.3%). South Korea's Kospi index slipped 0.8%
(up 4.4%). India's Sensex equities index fell 2.3%
(up 12.5%). China's Shanghai Exchange dropped 2.1%
to a three-year low (down 6.9%).
Freddie
Mac 30-year fixed mortgage rates fell 7 bps to
3.59% (down 63bps y-o-y). Fifteen-year fixed rates
slipped 3 bps to 2.86% (down 53bps). One-year ARMs
were down 3 bps to 2.63% (down 26bps). Bankrate's
survey of jumbo mortgage borrowing costs had 30-yr
fixed rates down 6 bps to 4.21% (down 68bps).
Federal Reserve Credit declined $7.0bn to
$2.804 TN. Fed Credit was down $32bn from a year
ago, or 1.1%. Elsewhere, Fed Foreign Holdings of
Treasury, Agency Debt this past week (ended 8/29)
rose another $4.5bn to a record $3.568 TN.
"Custody holdings" were up $147bn y-t-d and $81bn
year-over-year, or 2.3%.
Global central
bank "international reserve assets" (excluding
gold) - as tallied by Bloomberg - were up $422bn
y-o-y, or 4.2% to a record $10.575 TN. Over two
years, reserves were $2.015 TN higher, for 24%
growth.
M2 (narrow) "money" supply dropped
$25.7bn to $10.044 TN. "Narrow money" has expanded
6.5% annualized year-to-date and was up 5.7% from
a year ago. For the week, Currency increased
$2.1bn. Demand and Checkable Deposits fell
$23.4bn, while Savings Deposits increased $1.1bn.
Small Denominated Deposits declined $2.6bn. Retail
Money Funds fell $3.0bn.
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