By Doug Noland
Credit Bubble Bulletin: Doubled-Down
“The real trouble with this world of ours in not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.” G.K Chesterton
The S&P500 rose to a record 2,490.87 during Tuesday’s session at about the same time the VIX was trading down to 9.52. The DJIA reached a record 22,179 during Tuesday trading. At 5,973, the Nasdaq100 (NDX) was on track mid-day Tuesday for a record close. Tuesday saw the bank index (BKX) trade to a five-month high, with the broker/dealers (XBD) just shy of all-time highs.
“North Korea best not make any more threats to the United States. They will be met with fire and fury like the world has never seen. He has been very threatening … and as I said they will be met with fire, fury and, frankly, power, the likes of which this world has never seen before.”
The initial market reaction to President Trump’s Tuesday afternoon “fire and fury” comment was anything but dramatic. Market players have grown accustomed to bombast – apparently even when it concerns potential nuclear war. The S&P500 ended the session down about one-quarter of a percent. The VIX rose but only to 11.5. The bond market barely budged, though the already jittery currencies showed some instability.
Instead of dialing back his comments, the President Doubled-Down. The markets took notice. By Thursday the VIX had surged about 70% to trade above 17 (“Biggest weekly gain since December 2015”). U.S. and global stocks were under pressure. Junk bonds were getting hit (worst two-day decline of 2017), and even investment-grade corporates were under some pressure. In a rather unbullish development, U.S. bank stocks (BKX) sank 3.6% for the week. Broader U.S. equities indices were under pressure, with the mid-caps down 2.3% and the small-caps 2.7% lower.
All in all, it was an interesting – perhaps enlightening – week in the markets. At least for the week, the U.S. dollar was notable for weakness in the face geopolitical uncertainty. The yen (up 1.4%) and Swiss franc (up 1.1%) enjoyed some of their traditional safe haven appeal. Speaking of safe havens, Gold surged $31, or 2.4%. European equities trade poorly. German stocks dropped 2.3%, with previous high-flyers Spain (down 3.5%) and Italy (down 2.7%) under significant pressure. Italian 10-year sovereign spreads (to bunds) widened 10 bps.
August 9 – Wall Street Journal (Colin Barr): “Ten years ago this Wednesday, the first glimpses of the global financial crisis came into view. The French bank BNP Paribas froze three investment funds, saying a lack of trading in subprime securities made valuing them impossible. The bond market seized up, rattling investors and central bankers who previously soft-pedaled the notion that the U.S. housing bust would hit the economy. Aug. 9, 2007, marked the beginning of the most far-reaching economic disruption since World War II. The events that Thursday made clear that subprime-lending excesses wouldn’t be ‘contained,’ as Ben Bernanke, then Federal Reserve chairman, had predicted just months earlier. Yet few people appreciated the scope of the disaster that would unfold over the next 18 months.”
It’s simply difficult to believe 10 years have passed since the beginning of the so-called “worst financial crisis since the Great Depression.” It’s not beyond imagination to believe historians might look back to this week’s “fire and fury” as the start of the worst crisis in generations.
August 7 – Financial Times (John Authers and Alan Smith): “After the credit crisis began to unfold in the summer of 2007, many on Wall Street and in the City of London complained it was unprecedented and had been impossible to see coming. They were wrong. Speculative bubbles are rooted deep in human nature, and have been widely studied. History’s most famous bubble took root in the Netherlands almost four centuries ago — for tulips. The common elements to speculative bubbles are: An exciting and new ‘disruptive’ technology that is difficult to value in the short term, and whose long-term value is uncertain. Easy liquidity of markets so that shares or other securities can change hands quickly. The provision of cheap credit to pay for it. These classic elements were visible in, for example, canals and railroads, which both enjoyed speculative bubbles in the 19th century: In the 20th century, economic history was marked by a series of huge bubbles in critical markets. All followed almost identical patterns, and had a serious economic impact.”
The opening quote above – one of my old favorites – comes from Peter Bernstein’s classic “Against the Gods – The Remarkable Story of Risk.” The view that financial innovation and enlightened policymaking had tamed risk grew stronger throughout the nineties and then the mortgage finance Bubble period. Each crisis surmounted only emboldened New Age thinking. Monetary stimulus coupled with derivatives and sophisticated financial engineering ensured that virtually any type of risk could supposedly be hedged away. And as the mortgage Bubble began inflating precariously, a powerful view took hold that “Washington would never allow a national housing bust.” The GSEs, MBS, ABS, repo, CDOs and derivatives, Credit insurance – all things mortgage finance Bubble – enjoyed implicit government backing.
The 2008/09 financial crisis should have concluded an incredible era of dangerous risk misperceptions and flawed calculations. But the Federal Reserve and global central bankers Doubled-Down. Instead of the markets reverting back to more traditional (stable) views of risk, massive QE liquidity injections, zero rates and aggressive market liquidity backstops pushed risk analysis and perceptions only deeper into New Age Fallacy.
These days there’s virtually little in the way of risk that central bankers and government policymakers can’t address. Central banks became willing to fight risk aversion by directly inflating risk market prices, while simultaneously devaluing safe haven assets (with zero rates and inflationary policies). They could eradicate liquidity risk with promises of open-ended QE and the willingness to “push back against a tightening of financial conditions.” Policymakers also learned the value of concerted efforts to manage liquidity, manipulate prices, backstop markets and stabilize currency markets on a global basis.
Over time, markets began to appreciate the even political and geopolitical risks had been tamed. The 2012 “European” crisis demonstrated the new post-crisis reality that financial, economic and political risks would be met first and foremost by “whatever it takes” from central bankers and their electronic printing presses. Essentially any potential risk would ensure lower rates and more “money” printing for longer. It became clear that there was only one way to bet in the markets: with central bankers.
Yet one festering risk remained seemingly outside the purview of our inflationist central banks: geopolitical uncertainty. But even here things became clouded by a world inundated with “money” and surging securities markets. The global Bubble championed cooperation. With economic and financial fragility a global phenomenon, it was basically in each country’s interest to act in ways supportive of the global recovery. Of course, promote the securities markets! And it was also not the time to embark on geopolitically risky endeavors. Indeed, a global consensus developed to use economic/financial sanctions to dissuade countries from unconstructive behavior (i.e. Russia and Iran).
A relatively benign geopolitical backdrop unfolded – with economic expansion the focal point for most leading developed and developing nations. The focus on investment, trade and attracting global flows spurred a generally cooperative post-crisis backdrop, with nations seeking active participation within the global community. Of course, the major central banks were dominating the New Global Order. And with the monetary bonanza train having left the station, it was imperative not to be left behind. In their efforts to inflate securities markets and economies, global central bankers as well fostered a relatively quiescent period geopolitically. There were small countries that refused to participate, but they were irrelevant to the global financial and geopolitical backdrop.
With finance, the markets, economies and geopolitics so well-controlled, there should be little mystery surrounding meager risk premiums, record global stock prices and a VIX index below 10. It was certainly not sustainable, yet central bankers had succeeded in almost fully harnessing risk.
Let me try to explain why North Korea is potentially a huge market issue. It’s a small and irrelevant country financially and economically. Not only does it choose not to cooperate in the New Global Order, it would take great pride in being disruptive. And, most importantly, it has nukes as well as having made major strides recently in ICBM technologies.
Risks associated with North Korea are well outside the comfortable purview of central bank monetary management/manipulation – and they’re potentially catastrophic. The big problem is that market perceptions, behaviors, structures and prices have for going on a decade now been distorted by central bank’s dominance over all things risk. Disregarding risk has been consistently rewarded to the point where markets have been forced to disregard potentially catastrophic risks, including a nuclear confrontation with North Korea. Moreover, years of market risk distortions have deeply impacted the structure of the marketplace (i.e. the ETF complex, derivatives and speculating directly on risk metrics).
Going into the Presidential election, I believed markets would face significant selling pressure in the event of a surprising Donald Trump victory. It was clear from the campaign that a President Trump would be unconventional and not bound by traditional mores and behavior. He would be unpredictable like no President in modern times. And Trump was going to be tough, and likely bombastic and impulsive. No matter what, he would take great pains in doing things his way. For an already divided nation and a world of festering geopolitical instability, a Trump presidency came with extraordinary uncertainty and risk. As it turned out, over-liquefied and speculative markets were in the mood to disregard risk.
Let’s pray there’s a very low probability of a military confrontation with North Korea. Hopefully, over time some diplomatic solution will be found where North Korea halts development of nuclear and ICBM technologies. But I would argue that even this best-case scenario is problematic for the markets.
Key market vulnerabilities are being exposed. There’s always a major problem for highly inflated and speculative markets when it comes to hedging against risk – especially this type of undefinable risk. Indeed, this week provided a wake-up call for those that have been making a fortune writing variations of risk (“flood”) insurance during a period of over-liquefied financial markets (a risk “drought”). And the upshot of this mania in the “insurance” market has created a seemingly endless supply of cheap risk protection – readily available hedging vehicles that have kept players aggressively speculating throughout the markets.
I appreciated a Friday article by Gillian Tett of the Financial Times: “The Next Crash Risk is Hiding in Plain Sight.”
“Sometimes, market shocks occur because investors have taken obviously risky bets — just look at the tech bubble in 2001. But other crises do not involve risk-seeking hedge funds, or products that are evidently dangerous. Instead, there is a ticking time bomb that is hidden in plain sight, in corners of the financial system that seem so dull, safe or technically complex that we tend not to focus attention on them. In the 1987 stock market crash, for example, the time bomb was the proliferation of so-called portfolio insurance strategies — a product that was supposed to be boring because it appeared to protect investors against losses. In the 1994 bond market shock, the shocks were caused by interest rate swaps, which had previously been ignored because they were (then) considered geeky.”
Tett doesn’t believe the “financial system faces an imminent threat of another ‘boring’ time bomb causing havoc.” Her article did, however, mention the $4.0 TN ETF industry. And Marko Kolanovic, a senior JPMorgan strategist, estimates that “passive and quantitative investors now account for about 60% of the US equity asset management industry, up from under 30% a decade ago.”
When it comes to today’s global government finance Bubble, I would argue that “ticking time bombs” are more associated with risk misperceptions and “moneyness” (on an unprecedented global scale) rather than exotic debt instruments and egregious leverage. The collapse in the mortgage finance Bubble was not about subprime – but with the unappreciated risks embedded within Trillions of perceived pristine “AAA” mortgage securities and derivatives. The subprime crisis was in full bloom ten years ago today. Yet the S&P500 went on to all-time highs, with the systemic crisis not unfolding until about a year later.
Importantly, subprime tumult was the upshot of initial de-risking and de-leveraging behavior. The more sophisticated market operators began to respond to a deteriorating macro backdrop and escalating risk. Their moves to de-risk altered the market liquidity and pricing backdrops that led eventually to systemic crisis. As is typically the case, full-fledged systemic crisis erupted where price and liquidity risks were perceived to be minuscule – with a crisis of confidence in the money markets. In the case of 2008, panic unfolded in (the belly of the beast) the “repo” market.
Hopefully the North Korean situation will be resolved relatively quickly – perhaps mediated by the Russians and Chinese. A quick resolution would allow the markets to remain in this phenomenal backdrop of risk ignorance. But the longer this drags out the more problematic it becomes for the markets. This unfolding geopolitical crisis illuminates a major type of risk that’s been disregarded in the marketplace. If this illumination initiates de-risking/de-leveraging dynamics, this could mark an important inflection point for the risk markets. Rather than just waiting to see how this plays out, I would expect the more sophisticated players to take some risk off the table.
It’s worth noting that safe haven Treasury bonds rallied little in the face of a bout of “Risk Off” behavior. Not much “hedging” value left there. And in the event of a major military escalation, I’m not convinced that derivatives markets will function effectively. Reducing risk may (for a change) require liquidating holdings – stocks and corporate debt. And losses in equities and corporates would test the unprecedented trend-following flows that have chased inflating securities markets.
For a number of years now, I’ve referred to the “Moneyness of Risk Assets” issue – the perception of central bank-ensured safety and liquidity – that has been instrumental in Trillions of flows into ETFs and other “passive” strategies. It is Here Where the Wildness Lies in Wait. I wouldn’t bet on a continuation of low market volatility.