'In an early CBB, I resorted to my CPA training and went through (in painful detail) a series of debit and Credit journal entries to demonstrate how the GSEs could borrow in the money markets to purchase MBS in the marketplace, and how this "liquidity" could be "recycled" back through the money markets and borrowed again and again. In short, the GSEs would issue new short-term liabilities (IOUs) in exchange for "immediately available funds" (IAF). The IAF provided the purchasing power for MBS market purchases, where the GSE's transferred these funds to the seller. The seller would then deposit these IAF right back into the money market, where the GSE's (or others) could borrow them repeatedly (exchanging additional short-term IOUs for IAF).
This was akin to the old bank deposit multiplier (fractional reserve banking) but with zero reserve requirements. Traditionally, a bank might lend 80% of a new $100 deposit (20% reserve requirement), with this loan creating $80 of new funds that would be deposited at other institutions (where the next bank could lend 80% of the $80 deposit, then the next 80% of $64 and so on).
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The amount of global speculative leverage that has accumulated over the past (almost) decade is impossible to know. There is no transparency. Most assume it's not an issue. We'll know more over the coming months, but there is ample support for the view of unprecedented global speculative excess - across regions, countries and asset classes. I have posited that the global Bubble has been pierced at the "Periphery," and that contagion effects have begun gravitating to the "Core." This week offered additional confirmation of this thesis.''I continue to think back to the nineties. And to know where I'm coming from, I was convinced that finance had fundamentally changed in the nineties. No one, it seemed, was paying any attention. I would share my analysis with market professionals, academics, journalists and even Federal Reserve officials and the response was some variation of "Doug, you don't understand." After all these years, this most critical of issues remains unsolved.
I began posting the CBB analysis back in 1999, on a weekly basis attempting to explain what had changed; what was still changing; and what might be some of the momentous ramifications associated with combination of unfettered "Wall Street finance" and "activist" central bank monetary management.
It was not until 2007, when Pimco's Paul McCulley coined the term "shadow banking," that some began to take some notice. But with the following year's "greatest financial crisis since the Great Depression," desperation saw the focus shift to extreme monetary stimulus and basically using any means possible to reflate the securities markets and Credit more generally. It was not only that concerns for the inherent instability of contemporary market-based finance were pushed to the side. This high-powered finance machine was the centerpiece of central bank reflationary policymaking - around the world.
In an early CBB, I resorted to my CPA training and went through (in painful detail) a series of debit and Credit journal entries to demonstrate how the GSEs could borrow in the money markets to purchase MBS in the marketplace, and how this "liquidity" could be "recycled" back through the money markets and borrowed again and again. In short, the GSEs would issue new short-term liabilities (IOUs) in exchange for "immediately available funds" (IAF). The IAF provided the purchasing power for MBS market purchases, where the GSE's transferred these funds to the seller. The seller would then deposit these IAF right back into the money market, where the GSE's (or others) could borrow them repeatedly (exchanging additional short-term IOUs for IAF).
This was akin to the old bank deposit multiplier (fractional reserve banking) but with zero reserve requirements. Traditionally, a bank might lend 80% of a new $100 deposit (20% reserve requirement), with this loan creating $80 of new funds that would be deposited at other institutions (where the next bank could lend 80% of the $80 deposit, then the next 80% of $64 and so on).
I argued that contemporary non-bank market-based finance, operating outside of bank reserve requirements, created an "infinite multiplier effect." And I posited that "unfettered finance" essentially changed everything (market dynamics, policy, saving & investment, economic structure, etc.) In particular, "money" would circulate freely throughout the securities markets, inflating asset prices and incentivizing speculation. In particular, there was essentially unlimited cheap finance available for securities speculation, ensuring price Bubbles inflated by self-reinforcing speculative leverage. "Money" could be borrowed in, for example, the "repo" market to purchase securities, where the proceeds from the sale would be recycled right back into the money markets where it would be available to borrow again and again without limit.
It amounted to the greatest transformation in financial and market structure in history, all backstopped by the "activist" Federal Reserve and global central bankers. It was a New Era - a New Paradigm - that worked miraculously until its 2008 malfunction risked bringing down the global financial system. Most importantly, this incredible system of ever-expanding speculative leverage, seemingly endless liquidity and powerful asset Bubbles has a fundamental Defect: it doesn't function in reverse. Yet rather than addressing what went so terribly wrong, global central banks resuscitated and then bolstered this deviant financial apparatus, sending it on its merry way to reflate global markets and economies.
The past decade has seen similar dynamics to the mortgage finance Bubble period: expanding leverage and liquidity spinning around the system, promoting a self-reinforcing securities and asset inflation. The big difference during this cycle has been its unprecedented global scale. Central bankers and market bulls are fond of asserting that leverage is not an issue these days. Yet the most egregious leverage for this cycle has been in central bank and sovereign balance sheets. Liquidity created in the expansion of central bank balance sheets, in particular, circulated through the securities and funding markets where it has been "recycled" again and again…
A few examples: A hedge fund borrows at zero in Japan to lever in a higher-yielding dollar denominated EM debt "carry trade." This new liquidity flows into an EM banking system, where it is exchanged for local currency by the domestic central bank. The EM central bank then exchanges these dollar balances for U.S. Treasury bonds in the marketplace. The seller of Treasuries, say a hedge fund, then uses the proceeds from the short sale to leverage U.S. corporate debt. The corporate treasurer then uses the proceeds from the debt issue to repurchase equity shares, creating liquidity in the marketplace for the purchase of U.S. equities or even international shares - where it can begin the cycle anew.
Example 2: The ECB, expanding its liabilities, creates "money" to purchase Italian bonds in the marketplace. The seller transfers the proceeds from sale to one of the large German banks where it is held on deposit. The German bank then uses this liquidity to purchase U.S. agency securities from a U.S. broker/dealer that had previously acquired these GSE-issued securities with short-term money market "repo" financing. This "repo" loan is repaid, creating money market liquidity to finance other securities speculations. Or instead, the German bank (rather than holding deposits) buys short-term German debt from a hedge fund happy to short these securities at negative yields (borrow at negative interest-rates) to finance holdings of higher-yielding instruments in the U.S.
Example 3: An Asian hedge fund shorts (sells) 1-year Singapore sovereign debt at 1.88% and uses the proceeds to purchase Chinese corporate debt yielding 10%. A Chinese bank swaps the Singapore dollars into U.S. dollars, and then deposits these funds with the People's Bank of China (PBOC). The PBOC then exchanges these U.S. dollar balances to purchase Treasuries. The U.S. Treasury then uses this "money" to service its debts, liquidity that will then be available to purchase additional securities in the marketplace (or, perhaps, "money" to spend on imported Chinese goods, where the dollars make their way to the PBOC and then into the Treasury market).
Example 4: A U.S. pension fund shorts (sells) Treasuries to finance higher-yielding dollar-denominated EM debt. The pension fund buys bonds directly from a EM government, with the EM central bank exchanging local currency for dollar balances. The EM central bank then uses these dollars to purchase Treasuries, recycling liquidity right back to U.S. securities markets. The seller of the Treasuries, a hedge fund operating an "all weather" strategy, uses the proceeds from shorting Treasuries to finance a leveraged portfolio of stocks, fixed-income, EM securities and commodities - "recycling" this liquidity right back into U.S. and global financial markets.
Just a few basic examples of how various leveraged strategies fuel abundant liquidity flows around the globe. I suspect some of the greatest leverage is associated with sophisticated derivatives strategies - cross currency "swaps," myriad bond "carry trades," the proliferation of equities option strategies and ETF arbitrage, to name but a few. And as market prices rise and leverage increases, self-reinforcing liquidity abundance feeds the perception that the party can last indefinitely.
The amount of global speculative leverage that has accumulated over the past (almost) decade is impossible to know. There is no transparency. Most assume it's not an issue. We'll know more over the coming months, but there is ample support for the view of unprecedented global speculative excess - across regions, countries and asset classes. I have posited that the global Bubble has been pierced at the "Periphery," and that contagion effects have begun gravitating to the "Core." This week offered additional confirmation of this thesis.
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It was as if the dam finally broke. Ten-year Treasury yields jumped 17 bps this week to 3.23% (high since May 2011). Interestingly, long-bond yields were under even more pressure, as yields rose 20 bps to 3.41% (high since July '14). Mortgage securities fell under intense pressure, with benchmark MBS yields jumping 20 bps - surpassing 4.00% for the first time since July 2011. The old mortgage duration problem: When rates jump, borrowers are less likely to refinance their mortgages or upgrade to new homes. Investment-grade corporate debt was under pressure as well, with the LQD ETF declining 1.7% to a multi-year low.
The DJIA traded to a record high Wednesday before reality began to set in. The S&P500 also reached all-time highs in Wednesday trading before selling took over. The broader market was under heavy selling pressure.
It certainly had the appearance of incipient fear of tightening financial conditions - contagion having made important headway from the "Periphery" to the "Core." If, as it appears, global "Risk Off" is attaining some momentum, my thoughts return to Contemporary Finance's Defect: it doesn't function in reverse.'
- Doug Noland,
Contemporary Finance's Defect, October 6, 2018
Context'The [UN] report ought to be a wake-up call against the extremely counterproductive policies of central banks.''When the next recession arrives, they’re not going to know what hit them.'(Banking Reform - English/Dutch) '..a truly stable financial and monetary system for the twenty-first century..'