<blockquote>
'Today, I believe global faith in government policymaking has been badly shaken. There is now an appreciation that policymakers are running out of options. Confidence that fiscal and monetary stimulus ensures a sustainable global recovery has waned. There is recognition that massive stimulus can’t assure market stability; in fact, profligate fiscal and monetary measures will likely prove destabilizing. There is appreciation that global central bankers can’t guarantee normally-functioning markets. There is, these days, no denying that structural debt issues will be a serious ongoing problem. And, importantly, the world is increasingly keen to the severity of U.S. financial and economic problems. Indeed, the post-Greece backdrop beckons for reduced risk and less leverage. Yet the markets can – at least for a period of time – luxuriate in destabilizing policymaking-induced liquidity excess and dysfunctional markets.
...
Reminiscent of 2007/08, the initial crisis phase has unleashed wild volatility and instability throughout various markets....'</blockquote>
2010 vs. 2007By Doug Noland
August 06, 2010
SourceGreek and periphery European debt markets have stabilized. The euro is above 133, having now recovered back to April levels. Global risk markets have rallied, and commodities markets are again heading north. Throughout the markets, risk premiums have contracted meaningfully. Debt issuance at home and abroad has rebounded. I have posited that the Greek debt crisis provided another critical juncture for global markets. Others contend that Greece is a small country with limited global impact. Moreover, possible effects from Greek problems have diminished as the crisis has subsided. I’m unswayed.
The current environment increasingly reminds me of the long, scorching summer of 2007. The subprime crisis turned serious in early June. And not to pick on Ben Stein, but this week I went back and reread his August 12, 2007 New York Times article, “Chicken Little’s Brethren, on the Trading Floor.” Mr. Stein’s perspective at the time was in tune with the majority of analysts and pundits: subprime was just not that big of a deal; markets had way overreacted.
From his article: “The total mortgage market in the United States is roughly $10.4 trillion. Of that, a little over 13%, or about $1.35 trillion, is subprime… Of this, nearly 14% is delinquent… Of this amount, about 5% is actually in foreclosure… Of this amount… at least about half will be recovered in foreclosure. So now we are down to losses of about $33 billion to $34 billion… But by the metrics of a large economy, it is nothing. The total wealth of the United States is about $70 trillion. The value of the stocks listed in the United States is very roughly $15 trillion to $20 trillion. The bond market is even larger.”
Efforts to quantify potential damage from subprime or, more recently, Greece completely miss a fundamental facet of analyzing Bubble Dynamics: both were examples of the marginal borrower abruptly being denied access to liquidity/Credit in a highly speculative, hence susceptible, (“Ponzi Finance”) financial environment - thus marking critical junctures for their respective Bubbles. The Mortgage/Wall Street Finance Bubble, in the case of subprime, and the Global Government Finance Bubble, with respect to Greece, marked critical inflection points for both market perceptions and stability.
Amid this past month’s global market rally, perceptions have shifted to the view that the European debt crisis is behind us. Recalling the summer of ’07, the subprime crisis “officially” erupted in early June with the halting of redemptions by two structured mortgage product mutual funds managed by Bear Stearns (these funds collapsed later in the month). From a July high of 1,555, subprime worries hit the S&P500 for about 10%, with the market trading below 1,400 intraday on August 16th. Living up to market expectations, the Fed was quick to the rescue.
In an atypical inter-meeting move, the Federal Open Market Committee (FOMC) cut the discount rate 50 bps on August 17th, 2007. With an escalating subprime crisis, speculative markets moved confidently in anticipation of another aggressive round of monetary easing. The S&P500 rallied over 12% in less than two months. After having traded at almost 5.30% in mid-June, 10-year Treasury yields sank below 4.33% by early-September. Despite escalating mortgage tumult, (“safe haven”) benchmark Fannie MBS yields fell from 6.40% in June to 5.40% by late-November. The drop in market yields incited a rush to refi mortgages in late-2007 and into 2008. Dynamics that would culminate in a historic Credit market seizure and liquidity crisis were being masked by melt-up/dislocation in the Treasury and agency markets.
With fed funds at near zero, the FOMC has had little room to cut rates in response to the Greek/European debt crisis and a faltering U.S. recovery. The markets, however, clamored and the Fed delivered assurances that additional quantitative ease would be forthcoming as necessary. Akin to the summer of 2007, markets have rallied in anticipation of a further loosening of monetary conditions. Ten-year Treasury yields closed today at 2.82%, down 113 basis points from the early-April (pre-Greece) high. Benchmark MBS yields are down 111 bps to 3.56%.
The 2007 subprime eruption and the Fed’s response had a profound impact on perceptions throughout various markets. The dollar index – which had traded above 82 on August 16th 2007 – was down to 75 by late-November. The prospect for additional dollar devaluation gave further impetus to buoyant commodities markets. The Goldman Sachs Commodities Index jumped from 485 in August to end 2007 above 600 - on its way to almost 900 by mid-2008. Crude prices almost doubled in 10 months. Many of the “emerging” markets ran to frothy new highs – right before the big fall.
The implosion of the Mortgage/Wall Street Finance Bubble unfolded over about 18 months. There were powerful countervailing forces. On the one hand, a marked change in market perceptions was leading to a reduction in the availability of mortgage Credit. As new buyers/speculators lost their ability to obtain mortgages, it quickly became apparent that many key housing market Bubbles would soon burst. The U.S. housing mania and economic boom were doomed. This led to a broadening panic out of private-label MBS and a liquidity crisis for the overheated ABS/CDO marketplace. The dominoes had started to tumble.
Meanwhile, the behemoth Treasury, Agency and GSE MBS markets (with GSE securities enjoying a combination of explicit and implicit government guarantees) enjoyed big rallies. Liquidity problems in subprime-related sectors were for awhile more than offset by liquidity overabundance in the more dominant fixed-income markets. Ironically, the initial bursting of the mortgage finance Bubble – with all eyes fixated on the Bernanke Fed – fostered destabilizing liquidity excess. The declining dollar; leveraged “dollar carry trades;” an unwind of bearish bond positions and interest-rate hedges; a mortgage refi boom and resulting hedging against MBS pre-payment risk; Fed-induced speculation on lower market yields; a bout of safe-haven buying; and large foreign central bank Treasury purchases all combined to create an over-liquefied and highly-speculative market backdrop. The resulting liquidity-induced rally throughout global risk and commodities markets only exacerbated systemic vulnerabilities to the unfolding Credit and economic crises.
I highlight the 2007/08 experience as a reminder of how bursting Bubbles and financial crises can (tend to) evolve over many months – with surprising ebbs and flows and occasional confounding twists and turns. I don’t see anything in the current backdrop that tempts me to back away from my view that the Greek crisis marked a critical change in market perceptions. Those that dismissed how the subprime eruption had fundamentally altered the financial landscape would later regret their complacency.
Today, I believe global faith in government policymaking has been badly shaken. There is now an appreciation that policymakers are running out of options. Confidence that fiscal and monetary stimulus ensures a sustainable global recovery has waned. There is recognition that massive stimulus can’t assure market stability; in fact, profligate fiscal and monetary measures will likely prove destabilizing. There is appreciation that global central bankers can’t guarantee normally-functioning markets. There is, these days, no denying that structural debt issues will be a serious ongoing problem. And, importantly, the world is increasingly keen to the severity of U.S. financial and economic problems. Indeed, the post-Greece backdrop beckons for reduced risk and less leverage. Yet the markets can – at least for a period of time – luxuriate in destabilizing policymaking-induced liquidity excess and dysfunctional markets.
The dollar is in trouble. Our currency has now dropped for nine straight weeks, sinking to a near 15-year low against the yen. Crude oil traded above $82 this week. Wheat prices are up about 50% over the past month. The last thing our struggling economy needs right now (in common with 2007/08) is surging energy and food prices.
And there is clearly interplay at work between tumult in the currencies and dislocation in our fixed income markets. Fed talk of QE2; rumors of the Administration forcing Fannie Mae/Freddie Mac to refinance and/or reduce principal on troubled mortgages; the potential for a wave of mortgage refinancings; and the likelihood that many have been caught on the wrong side of a major move in market yields have Treasury, agency and MBS yields in near freefall.
August 2 – Bloomberg (Caroline Salas and Jody Shenn): “For all the good the Federal Reserve’s $1.25 trillion of mortgage-bond purchases have done, they’ve also left part of the market broken. By acquiring about a quarter of home-loan bonds with government-backed guarantees to bolster housing prices and the U.S. economy, the Fed helped make some securities so hard to find that Wall Street has been unable to complete an unprecedented amount of trades. Failures to deliver or receive mortgage debt totaled $1.34 trillion in the week ended July 21, compared with a weekly average of $150 billion in the five years through 2009… The difficulty of executing transactions may eventually drive investors away from the $5.2 trillion mortgage-bond market, which has historically been the most liquid behind U.S. Treasuries, potentially causing yields to rise, according to Thomas Wipf… The unsettled trades also stand to exacerbate the damage caused by the collapse of a bank or fund. ‘You’re adding systemic risk into the market,’ said Wipf, chairman of the Treasury Market Practices Group and the… head of institutional-securities group financing at Morgan Stanley. ‘Investors are taking on counterparty risk in trades they didn’t intend to take on.’ An incomplete agreement can lead to a ‘daisy chain’ of unsettled trades because a broker-dealer acting as a buyer in one transaction may fail to deliver those bonds as a seller in another, according to Alexander Yavorsky, a senior analyst at Moody’s… Investment banks are required to hold capital against both sides of the trades, which also makes the agency mortgage-backed market less attractive to make markets in…”
It is worth noting that Treasurys held in reserve by foreign central banks at the New York Federal Reserve Bank have surged $74bn in just seven weeks. Dollar weakness appears, once again, to be forcing foreign central banks back into the role as “backstop bid” for the dollar in global currency markets. These dollar balances are then “recycled” back into our Treasury market, a dynamic that does not go unrecognized by the speculator community. This presses market yields only lower, increasing the risk of prepayment on mortgage securities and forcing additional interest rate hedging (further exacerbating the decline in market yields). And once a market dislocates, many will pile on in search of easy speculative profits.
With Treasury, Agency and MBS prices melting up (yields in melt down), key markets enjoy extraordinary, albeit destabilizing, liquidity abundance. Understandably, market participants dismiss talk of U.S. structural debt issues. Many will justify the move on fundamental grounds – “It’s deflation, stupid!” Ironically, collapsing yields, the sinking dollar, surging commodities, recovering global risk markets and the onslaught of global liquidity create a backdrop conducive to future inflation surprises.
Reminiscent of 2007/08, the initial crisis phase has unleashed wild volatility and instability throughout various markets. Some can see that the glass is less than half empty, while attentive central bankers and sinking yields have most viewing things as positively full. The havoc and misperceptions create an increasingly dysfunctional market landscape. Over time, the volatility, uncertainty and escalating market stress will prove a subprime-like wrecking ball on confidence. I need to go back and count the number of trading sessions in 2008 between seemingly over-liquefied markets and Credit market seizure.
My expectation remains that markets, having disciplined Athens and initiated austerity in the euro-zone, will inevitably set its sights on Washington profligacy. Too reminiscent of the Mortgage/Wall Street Finance Bubble, the markets seem determined to ensure that this disciplining process is methodically delayed until the very maximum levels of Credit excess, speculative froth, market distortion, and systemic vulnerability have been achieved.