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Fed-Led Chaos Deepens
Commentary and weekly watch by Doug Noland
The Alchemy of Finance is one of the greatest financial books ever written. In this 1988 classic, George Soros developed his thesis of how finance and the markets operate and then tested his analytical framework in real life market circumstances. I have drawn heavily from Mr Soros' body of work in developing my global macro credit and markets analytical framework. In the spirit of
The Alchemy, it is imperative to constantly challenge and test my thesis in the real world and be willing to adapt to ensure the framework is capturing real world dynamics. It is absolutely fundamental for theoretical concepts and analytical frameworks to be reality based.
My thesis in a snapshot: a unique period of unfettered global credit has spawned myriad historic bubble dynamics. The unprecedented policy response, fiscal and monetary, at home and abroad, to the bursting of the 2008 mortgage/Wall Street finance bubble unleashed the global government finance bubble. This bubble was fueled by unprecedented growth in global sovereign borrowings and the unprecedented expansion of global central bank balance sheets, along with associated market pricing and risk-taking distortions. Importantly, this "global reflation" stoked already overheated "developing" country credit systems and economies to the point of dangerous bubble fragilities.
This view is supported by extraordinary credit expansion throughout China, Brazil, India and "developing" economies more generally. I have argued that post-2008 stimulus pushed China into a dangerous terminal phase of credit bubble excesses.
I have drawn parallels between last year's Greek crisis and the eruption of subprime in 2007. Both were the initial cracks (marginal borrowers denied access to inexpensive market-based finance) in respective historic bubbles (2007: US mortgage/Wall Street finance; 2010: global sovereign debt). With Greek crisis contagion having this summer spread to the third-largest issuer of sovereign debt in the world (Italy) and having severely impaired the European banking system, I have seen ample confirmation of this facet of my thesis.
From my vantage point, last week appeared to provide another critical global crisis inflection point. In particular, escalating market tumult and contagion effects afflicted the "developing" currencies and bond markets. To that point, they'd been fairly resilient. Yet global de-risking/de-leveraging dynamics seemed to lurch forward – and ever closer to the point of turning uncontrollable. I'll suggest that the coming weeks will be crucial.
The consensus view holds that the developing economies and credit systems are robust and, as such, will prove resilient in the face of developed-world structural financial and economic woes. I fear that the "developing" systems have themselves become acutely vulnerable to the downside of bubble dynamics.
The soundness of "developing" credit systems has quickly become a critical issue. Conventional analysis doesn't foresee major problems. The popular bullish thesis is premised on powerful secular growth dynamics. From my analytical perspective, there is acute global systemic vulnerability to the reversal of what were massive financial flows (trillions?) to the developing world.
And it may be nebulous, but there is the issue of possibly enormous carry-trade inflows that previously emanated from the leveraged speculating community (sell low-yielding dollar securities and take proceeds to leverage in higher-returning global risk assets). The developing world also enjoyed huge investment fund flows and foreign-based capital investment. The global banking community, especially the European financial goliaths, also made a major push to capitalize on robust developing lending, fund flow, mergers and acquisitions, and asset inflation backdrops.
I was last week recalling the 2001/2002 post-tech bubble monetary debate. Back then, the intellectual deflation hysteria fixated on the need to reflate the general price level. With the year-over-year change in the US consumer price index (CPI) in steady decline for much of 2001 and touching a low of 1.0% in 2002, there was a big push to have the Federal Reserve orchestrate sufficient monetary ease to inflate the CPI out of the deflationary danger zone.
I argued at the time that there was in reality no general level of consumer prices for the Fed to actively manipulate. Instead, there were myriad complex supply and demand pricing dynamics throughout the US and global economy, as well as mercurial asset and financial market trading dynamics.
Indeed, the most direct impact of Fed policy interventions (as had been repeatedly demonstrated by 2001) was in the asset and securities markets. In particular, by 2001/02 it was readily apparent that a powerful inflationary bias had taken root both in sophisticated leveraged speculation and throughout the US housing sector. The Fed's push to reflate CPI unleashed powerful bubble dynamics throughout mortgage finance, the hedge funds/Wall Street proprietary trading desks/derivatives/structured finance, and US (and global) housing markets.
At the time, the most vocal proponents of ultra-loose money, including top officials at the Fed, were more than content to risk some excess in housing to ensure a successful recovery and victory over deflation. The economy was stagnant, the corporate debt market was in tatters, technology stocks had collapsed and equities were generally out of favor. So the still robust government-sponsored enterprises (GSEs), the (government-backed) agency and mortgage-backed securities (MBS) marketplace, the opportunistic hedge funds, and the resilient housing sector were viewed as the powerful locomotive candidates available for system credit reflation.
It's certainly no coincidence that, at the epicenter of the 2008 financial crisis, these credit expedients came back to haunt the system. Importantly, the most robust reflationary monetary processes (ie GSE risk intermediation, Wall Street structured finance, hedge fund leveraging and the inundation of finance upon US housing markets) and inflationary biases (ie home and security prices, consumption, and consumption-based investment) were exploited and pushed to dangerous bubble extremes. At the end of the day, policy was successful in moderately reflating the so-called general price level but at an immoderate cost to financial and economic system stability.
The 2008 crisis became a full-fledged global private-debt and economic crisis. Calls to aggressively battle the "scourge of deflation" became only more impassioned (if you disagreed, you were clearly a moron). Interestingly, analytical focus moved well beyond the general price level. With the Fed admitting that its traditional monetary mechanism had broken down ("pushing on a string"), the Ben Bernanke-led Fed moved decisively toward targeting asset prices – especially bond yields and our stock market.
Zero rates and the massive expansion of the Fed's balance sheet could at the same time ensure marketplace liquidity, incentivize speculation in risk assets, and further devalue our beleaguered currency. A massive expansion of federal debt and a weaker dollar would bolster US business performance and spur a domestic economic rebound. And it certainly didn't hurt that loose money would also work to sustain developing-world growth dynamics – locomotives to help pull the world economy out of the post-2008 doldrums.
Replaying the acquiescence to US mortgage excesses, I believe global policymakers in the post-2008 panic were willing to look the other way to massive developed sovereign debt issuance and enormous excesses and distortions in both the world's financial apparatus and developing credit and economic systems. Massive deficits in Europe's periphery (as well as in the US); a miraculous resurgence in leveraged speculation, carry-trade flows and derivative trading; and extreme global imbalances were simply (in 2003-2007 fashion) disregarded. These were, after all, this reflationary cycle's most robust monetary processes and inflationary biases; this cycle's reflation expedients and growth locomotives.
It is this analytical backdrop that makes me fearful that the global crisis has commenced another escalation phase. Heightened uncertainty has moved well beyond Greece, the periphery, and the greater euro zone. There are now major questions – and worries – with respect to even the Chinese and developing Asian booms. It is worth noting that Chinese credit default swap (CDS) prices surged 38 basis points (bps) last week to 197 bps, up about 110 bps from the July low to the highest level since early-2009. CDS prices have spiked throughout the developing markets – Eastern Europe, Asia and Latin America.
And so we'll be watching attentively. Thus far, there is mounting support for the systemic fragility thesis with respect to the entire developing world. And despite the positive outcomes in voting for expanding the scope of the European Financial Stability Facility, one had to squint this week to see improvement in Europe's desperate financial situation. Meanwhile, there was evidence of ongoing pressure on global carry trades and the leveraged community more generally.
Keep in mind that the gigantic (hedge and mutual) fund operators became only more monstrous over the past few years. It will not be easy for the dominant players, especially in the face of faltering marketplace liquidity and diminished hedging markets, to get their trading books repositioned for today's new realities.
I'd be remiss if I failed to note that Fed chairman Bernanke was compelled to dangle the carrot of a third round of quantitative easing (QE3) a bit last week. The initial, yet fleeting, response was a little market-comforting relief from recent dollar strength. I assume that QE3 will be forthcoming, although when it eventually arrives it will likely be met with disquieting internal Fed dissent, political risk, public angst and, perhaps, a lot of market indifference.
With each passing day of global de-risking/de-leveraging fallout, the market better appreciates that quantitative easing is suffering from a diminished capacity to sustain global bubble dynamics. The reality is that the scope of QE3 would have to be enormous to reverse the unfolding global bursting-bubble backdrop. This will create a serious dilemma for the Fed come decision time (a QE2-sized QE3 risks disappointing the markets, while a trillion handle might just push shock and awe to the breaking point). And while it surely sounds silly these days even to mention it, let's also not completely disregard the festering issue of a policy-induced Treasury market bubble matched against he recent 3.8% year-on-year increase in consumer prices.
