Unwitting Beneficiary? - By Doug Noland

<blockquote>'Bubbles are not obvious while they are inflating, and the Global Government Finance Bubble is no exception. The key characteristics of Credit Bubbles are various Credit excesses, distortions to the price and flow of finance, and heightened speculation. While the massive issuance of government debt is readily apparent, pricing distortions have been more subtle.

...

It has been fundamental to my Bubble thesis that the finance underpinning global recoveries has been unsound, unstable and unsustainable. In particular, extraordinary stimulus measures incited a move by the speculators aggressively back into global risk assets. The massive pool of global speculative finance – having been reined in during the 2008 crisis – quickly returned to near full force and power. Leverage that had been taken down during the crisis was ratcheted right back up. Carry trades that had unwound during the crisis were wound right back up. Unprecedented policy stimulus and market intervention had again made it too easy to garner speculative profits.

...

The collapse in yields must have caused havoc for those hedging interest rates risk in the multi-Trillions market for mortgage-backed securities. With our mortgage market essentially nationalized, there is little attention paid to MBS these days. Yet interest-rate hedging continues to play a crucial role throughout the Credit markets. I’ll assume that huge hedging programs helped push Treasury yields to recent depths. It’s exactly this type of volatility and uncertainty that forces players to pare back risk. And it’s rising risk aversion that will pressure financial conditions and fuel liquidity concerns. The markets have passed an important inflection point, and faltering markets are certainly not good for fragile confidence.'</blockquote>

Unwitting Beneficiary?

By Doug Noland
May 28, 2010
Source

How about a brief review of “where we’ve been; where we are; and where we might be heading”?

The year 2008 witnessed the collapse of the Wall Street/mortgage finance Bubble. This historic Bubble was the latest of a long series of Bubbles going back at least to the late-eighties’ (“decade of greed”) excesses emboldened by Alan Greenspan’s 1987 post-market crash liquidity injections and assurances. This serial Bubble episode saw each Bubble emerge bigger than its predecessor – which required ever-increasing policymaker post-Bubble market interventions resulting in only deeper market distortions.

I have posited that unprecedented policymaker response to the 2008 Bubble collapse inflated a Global Government Finance Bubble. Arguably, this Bubble has the potential to be the biggest and most dangerous yet. It’s certainly complex and poses analytical challenges. At least here at home, Credit excesses have gravitated to the heart of the monetary system (government and Federal Reserve Credit).

Many scoff at the notion of yet another huge Bubble. With a focus on asset valuation, they would argue that stock and real estate prices are nowhere near Bubble territory. They would likewise dismiss the notions of a “Bubble economy” and attendant Credit addiction and systemic fragilities. The conventional view holds that the U.S. economy enjoys long-term growth dynamics that will over time hold sway over cyclical setbacks. Aggressive fiscal and monetary stimulus was, from their perspective, necessary to counteract extraordinary Credit system stress and to shove the economy back toward its sustainable growth track.

Bubbles are not obvious while they are inflating, and the Global Government Finance Bubble is no exception. The key characteristics of Credit Bubbles are various Credit excesses, distortions to the price and flow of finance, and heightened speculation. While the massive issuance of government debt is readily apparent, pricing distortions have been more subtle.

Fundamentally, this Bubble’s main price distortions emanate from the market perception that synchronized global fiscal and monetary policies will sustain global financial and economic recoveries. This creates a dynamic where massive issuance of sovereign debt is generally priced in the marketplace with meager little risk premiums. Similarly, the perception that markets and economies are underpinned by government policies ensures that debt instruments throughout – certainly including U.S. corporates, municipal debt, agencies, and mortgages – trade at narrow risk spreads to sovereigns. It’s the ultimate “too big to fail.”

It has been fundamental to my Bubble thesis that the finance underpinning global recoveries has been unsound, unstable and unsustainable. In particular, extraordinary stimulus measures incited a move by the speculators aggressively back into global risk assets. The massive pool of global speculative finance – having been reined in during the 2008 crisis – quickly returned to near full force and power. Leverage that had been taken down during the crisis was ratcheted right back up. Carry trades that had unwound during the crisis were wound right back up. Unprecedented policy stimulus and market intervention had again made it too easy to garner speculative profits.

The influx of speculator finance upon global risk markets inflated prices and stoked returns, while zero interest rates here at home incited a massive flow of finance from relative safety out to inflating global securities markets. Money market fund assets peaked the second week of January, 2009, at $3.922 TN. In the past 15 months, over $1.0 TN has flowed from the money fund complex out to global risk markets.

As a proxy for financial conditions, junk bond spreads peaked at over 1,300 bps in January, 2009. At last month’s (April 23rd) trough, junk spreads had contracted 835 bps all the way down to 478 bps. Similar risk premium collapses occurred in investment grade corporates, agency debt, mortgage-backed securities, and municipal bonds. It was one of history’s great reversals in market perceptions/financial conditions.

This dramatic loosening of financial conditions inflated global securities prices. Huge rallies in the risk markets played a significant role in bolstering confidence. This combination of loose finance and improved confidence was instrumental in fostering economic recovery. The bounce back in economic activity then supported the bubbling markets and emboldened the speculators. That’s where we’ve been.

Over the past month, markets have gone from close to euphoria to near panic. The global financial Bubble ran smack up against an expanding Greek debt crisis, a tightening of Chinese mortgage Credit, and a tightening regulatory noose around the U.S. financial sector and speculative finance more generally. Complacent, highly speculative and over-liquefied securities markets were bludgeoned by losses, contagion effects, de-leveraging, and general mayhem.

The speculator world was positioned for the Global Government Finance Bubble. Led by the U.S. Treasury, massive synchronized fiscal stimulus was expected to support worldwide economic recovery. Led by the U.S. Federal Reserve, massive synchronized monetary stimulus was to ensure liquid and accommodative global securities markets. And as the currency of the leading reflationist nation, the dollar was viewed in the markets as fundamentally weak and vulnerable. Markets anticipated an unsound dollar would continue to bolster global reflationary forces. With such a strong inflationary bias throughout the global risk markets, borrowing at near zero rates in dollars or yen to leverage in any assortment of risk trades appeared an unusually compelling bet.

The Greek debt crisis blew a lot of expectations – and leveraged trades - out of the water. As Eurozone policymakers bumbled, susceptible markets buckled. The belief that assertive policymakers would move quickly to avert financial crisis proved too optimistic. Soon, the specter of Greek debt default or reorganization fomented dislocation in the Credit default swap (CDS) market. Contagion effects were transmitted quickly through the CDS markets to Portugal, Spain, Italy and Ireland. With European debt markets in disarray, the euro came under heavy selling pressure. Yen and dollar strength gained momentum, with global leveraged players suddenly finding themselves on the wrong side of quickly changing marketplace. The unwind of leveraged trades led to a contraction of marketplace liquidity and increasingly problematic contagion effects throughout the system. And Credit system de-leveraging, faltering liquidity, and sinking markets provoked a panicked reassessment of global commodities pricing and growth dynamics.

This week from St. Louis Federal Reserve Bank President James Bullard (quoted by MarketNews International’s Steven K. Beckner): “The U.S. may actually be an unwitting beneficiary of the crisis in Europe, much as it was during the Asian currency crisis of the late 1990s. This is because of the flight to safety effect that pushes yields lower in the U.S…. Of course the U.S. also has its own fiscal problems that must be directly addressed in a timely manner if the nation is to maintain credibility in international financial markets.”

So far, I guess one could make the “unwitting beneficiary” case. Treasuries have rallied strongly along with the dollar. As someone who has managed short positions for over two decades, I don’t necessarily equate dramatic price spikes with sound underpinnings. Indeed, it is so often the case that stocks/markets rally sharply right as weak fundamentals are about to emerge; one final short squeeze and price dislocation before the fall. The experience of technology stocks in early-March 2000 quickly comes to mind. Clearly, many were caught short the dollar and Treasuries. Especially considering the massive ongoing supply of Treasuries and the Fed’s zero rate policy, the upside for Treasuries and our currency had seemed rather limited.

Thus far, the bulls are not dissuaded. And I’ll be the first to admit that over the years (including during the Asian crisis) the U.S. economy was on the receiving end of stimulus benefits emanating from global crises. A safe-haven bid to the dollar and Treasuries would lead immediately to lower mortgage borrowing costs (and ballooning GSE balance sheets!). In short order, homeowners would extract equity while refinancing mortgages. A jump in home transactions would boost both prices and the amount of mortgage Credit slushing around the economy. Those dynamics, however, are dead and buried in the post-housing mania era. With such fragile underpinnings, I see no real U.S. benefits from global financial tumult.

In my “Issues 2010” piece from early January, I argued the case for 2010 being a “Bubble year” with “bi-polar outcome possibilities.” It was my view that, as long as Bubble Dynamics were accommodated by loose financial conditions, Bubble effects would be free to strengthen and broaden. At the same time, fragile underpinnings and an exceptionally speculative financial backdrop left the system vulnerable to any tightening of Credit conditions.

So, where might we be heading? Likely, prospects will be determined by developments in financial conditions. Will they remain loose and render ongoing support to the Bubble? Will markets regain their composure to the point of ensuring sufficient liquidity and Credit expansion? Or will finance tighten – has Credit Availability already tightened? Did the Greek debt crisis pierce the Global Government Finance Bubble – akin to the subprime collapse dooming the Wall Street/mortgage finance Bubble? I don’t believe there’s room for a middle ground here – no “muddle through” – its boom or back to bust.

Well, I believe finance has tightened and this tightening will not prove fleeting. The global Bubble has been pierced, a result of Greece – although the catalyst could have as easily been developments in the U.S. or China. But since crisis erupted initially in the Eurozone, the dollar/Treasuries have benefited thus far from de-leveraging and some safehaven perceptions. Many are programmed to interpret this as good news for U.S. recovery, although the important news is that market perceptions have changed; markets have become hyper-volatile; and the backdrop is so uncertain that speculators and investors will choose - or be forced to - rein in risk-taking.

The waves of liquidity unleashed through speculator leveraging and the flight out of safehaven assets has run its course. As we’ve seen over the past few weeks, markets can go from seemingly over-liquefied to illiquid the moment speculators reverse course and head for the exits. The markets have been reminded of this harsh reality and behavior will change. Others would argue that there is no crisis in the U.S. Credit system and, with Treasury yields so low, financial conditions have actually loosened. I would counter that it’s a global financial Bubble and destabilizing contagion effects were unleashed with the big rally in Treasuries.

The collapse in yields must have caused havoc for those hedging interest rates risk in the multi-Trillions market for mortgage-backed securities. With our mortgage market essentially nationalized, there is little attention paid to MBS these days. Yet interest-rate hedging continues to play a crucial role throughout the Credit markets. I’ll assume that huge hedging programs helped push Treasury yields to recent depths. It’s exactly this type of volatility and uncertainty that forces players to pare back risk. And it’s rising risk aversion that will pressure financial conditions and fuel liquidity concerns. The markets have passed an important inflection point, and faltering markets are certainly not good for fragile confidence.