By Doug Noland
Credit Bubble Bulletin: New Age Mandate
A journalist’s question during Mario Draghi’s ECB post-meeting press conference: “…There was a sharp reaction from financial markets to your Sintra speech. You must have looked at the Fed experience of 2013. Is there any concern in the Governing Council that the so-called tantrum or a similar reaction can happen in the eurozone when you start discussing changes in your stance?”
Draghi: “I won’t comment on market reactions, but let me give you the bottom line of our exchanges: basically, inflation is not where we want it to be, and where it should be. We are still confident that it will gradually get there, but it isn’t there yet, and that’s why the Governing Council reiterated the forward guidance, the asset purchase programme, the interest rates and all this package of monetary accommodation; and reiterated that the present very substantial monetary accommodation is still necessary. Let me read the introductory statement: ‘Therefore a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to gradually build up and support headline inflation developments in the medium term.’
Draghi continued: “But let me just make clear one thing: after a long time, we are finally experiencing a robust recovery, where we only have to wait for wages and prices to move towards our objective. Now, the last thing that the Governing Council may want is actually an unwanted tightening of the financing conditions that either slows down this process or may even jeopardise it; and that’s why we retain the second bias, or let’s call it, reaction function. ‘If the outlook becomes less favourable or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase our asset purchase programme in terms of size and/or duration.’ And I think the Governing Council has given enough evidence that when flexibility is needed to achieve its objectives, it has been very able to find all that was needed. So that’s why we keep this bias.”
This exchange gets to the heart of a momentous issue. Recall the swift market reaction to “hawkish” Draghi’s comments from Sintra (June 26-28 ECB Forum on Central Banking) and, soon after, ECB officials expressing that markets had misinterpreted his remarks. Markets this week were awaiting “dovish” clarification. Draghi soundly beat expectations.
The above (astute) question referred to the Fed’s 2013 “taper tantrum” experience. While it received scant attention at the time, Bernanke’s – “The Fed will push back against a tightening of financial conditions” – response to incipient market instability proved a pivotal extension to his historic monetary experiment. In hindsight, this was the chairman’s vague introduction of a New Age Mandate: Central Banks Will Underpin Risk Embracement Throughout the Financial Markets. The Fed was prepared to employ aggressive stimulus measures in the event of self-reinforcing risk aversion and resulting marketplace liquidity issues. The Federal Reserve was signaling that it was ready to respond quickly to de-risking/de-leveraging dynamics – over time profoundly impacting risk-taking and securities and derivatives pricing throughout the markets.
No longer would the Federal Reserve confine market-supporting measures to crisis backdrops. Apparently no reason not to upgrade the Fed put to 24/7. Their liquidity backstop was to ensure that selling momentum was not allowed to materialized. Sure enough, Bernanke’s New Mandate was a huge hit in the marketplace (S&P500 up more than 50% since 2013) and has been readily adopted by central bankers around the globe, certainly including Draghi’s ECB. So few detractors. And typical of government “mandates,” once adopted they’re almost impossible to repeal.
“Will push back against a tightening of financial conditions” explains at least a few so-called “conundrums.” Why is the VIX (and risk premia more generally) so low? Why are sovereign yields remaining near historic lows despite the Fed raising rates and other central banks planning to do the same? How can equities ignore mounting political and geopolitical risks?
If central banks have become so keen to protect markets from risk aversion, why shouldn’t the cost of market “insurance” remain extraordinarily low. Why wouldn’t speculators gravitate to products fashioned to profit from providing myriad forms of market risk mitigation (hawking flood insurance during a drought)? And, importantly, as Bubble risks escalate, why would sovereign yields around the globe not discount the high probability that central banks will at some point be called upon to make good on their New Mandate – i.e. respond to faltering Bubbles with aggressive new QE programs with enormous quantities of bonds/securities to purchase?
I am reminded of chairman Greenspan’s asymmetrical policy approach – aggressively slashing rates when markets falter, while quite cautiously increasing rates while loose conditions fuel destabilizing excess. The Greenspan Fed’s policy approach during the nineties provided a competitive advantage to U.S. securities markets. This “advantage” was a powerful magnet attracting global speculative flows, inflows instrumental in fueling “king dollar” distortions.
I refer to Mario Draghi as “the world’s most important central banker.” He these days holds command over the markets’ preeminent liquidity backstop – in the most explicit terms. The Yellen Fed, raising rates and discussing balance sheet normalization, lacks the readiness enjoyed by Draghi. As such, the Fed now takes a backseat when it comes to the competitive advantage Draghi confers upon European securities markets.
In his press conference, Draghi refused to bite when questioned about the strong euro. This was taken as a lack of concern – and the euro surged. I expect Draghi is monitoring euro strength with increasing concern, though he prefers not to publicly challenge the currency market. I also assume he is skeptical of euro strength, expecting Fed policy normalization to be dollar positive. Perhaps he doesn’t at this point fully appreciate the degree to which his market backstop underpins the euro, especially with a more dovish Yellen Fed and increasingly combustible Washington.
Italian 10-year yields sank 22bps this week to 2.07%. The Italian government borrowing for 10 years at about 2% is today’s poster child for wildly distorted markets and inflated securities values. Spanish yields dropped 20 bps this week to 1.45%, and Portuguese yields fell 24 bps to 2.91%. Now down 180 bps y-t-d, Greek 10-year yields ended the week at 5.22%. Draghi’s “whatever it takes” has worked wonders, especially for European periphery debt markets.
It’s worth mentioning that Germany’s DAX equities index sank 3.1% this week. France’s CAC 40 fell 2.3%, with major equities indices down 2.1% in Spain and 1.4% in Italy. European equities have been a hot, crowd-favorite trade – and this week took their turn for a bout of Crowded Trade Punishment. Draghi’s explicit liquidity backdrop provided a competitive advantage for the euro, as well as for European debt compared to European equities.
Draghi’s predecessor, Jean-Claude Trichet, had it right with his “I will not pre-commit to anything.” The Trichet ECB appreciated that pre-committing on policy would spur financial speculation and distortions. Trichet’s resolve on such an important issue must have been at least partially a reaction to Fed policymaking – and how Greenspan’s penchant for signaling the future course of policy cultivated destabilizing hedge fund and derivatives leveraged speculation. It’s ironic that Draghi not only discarded “will not pre-commit to anything,” he adopted the Greenspan and Bernanke approach but in a more audacious scheme.
There is no doubt that central bank liquidity backstops have promoted speculation, securities leveraging and derivatives market excess/distortions. I also believe they have been instrumental in bolstering passive/index investing at the expense of active managers. Who needs a manager when being attentive to risk only hurts relative performance? And the greater the risk associated with these Bubbles – in leveraged speculation, derivatives and passive trend-following – the more central bankers are compelled to stick with ultra-loose policies and liquidity backstops.
After all, who will be on the other side of the trade when all this unwinds? Who will buy when The Crowd moves to hedge/short bursting Bubbles? This is a huge problem. Central bankers have become trapped in policies that promote risk-taking, leveraging and hedging at this precarious late-stage of an historic Global Bubble. These days, central bankers cannot tolerate a “tightening of financial conditions,” and they will have a difficult time convincing speculative markets otherwise.
Speaking of credibility issues…
July 20 – Bloomberg: “China’s deleveraging campaign is taking on its toughest target yet: the public sector itself. While up to now policy makers have focused on a build-up of liabilities at smaller banks and big private-sector companies, President Xi Jinping has made clear that local government authorities and China’s behemoth state-owned enterprises too must restrain borrowing. Xi’s comments at a top financial-regulatory gathering last weekend were the latest signal of determination to head off any future destructive debt-bubble deflation. It’s perhaps the hardest leverage nut to crack, because Communist Party officials have for decades risen through the ranks by borrowing to fund growth — whether at local authority levels or atop an SOE monopoly… ‘Policy makers will likely seize this rare opportunity to reduce leverage in the economy in a deeper, longer and more thorough campaign,’ said Helen Qiao, chief greater China economist at Bank of America Merrill Lynch in Hong Kong. ‘We will see more measures being rolled out in the second half of 2017 and 2018,’ she said… ‘Focusing on cutting excess leverage in real economy, instead of in the financial sector’ came as a surprise to some, said Zhu Haibin, chief China economist at JPMorgan… in Hong Kong. ‘Cutting leverage means the gap between credit growth and nominal GDP growth will narrow — but that could have knock-on risks and drag on economic growth itself.’”
It’s helpful to remind ourselves that the Chinese have limited experience with runaway Credit Bubbles. This is their – borrowers, lenders, regulators and officials – first experience with a mortgage finance Bubble. They’ve never had to contend with overseeing the world’s biggest banks (involved in all kinds of things all over the place). They’ve never had small banks borrow Trillions in the inter-bank lending market. So-called “shadow banking” has never been such a powerful force – throughout the markets and real economy. The Chinese have limited experience with “repo” financing and the murky world of derivatives. They are new to corporate debt securities boom and bust cycles. They’ve never had to contemplate complex counter-party issues where the counter-parties have become massive global financial players.
For years now, I’ve chronicled Chinese policymakers taking a way too timid approach to managing mounting Credit Bubble excess. In the process, they brought new meaning to Greenspan’s “asymmetrical:” timid little baby steps against colossal financial and economic maladjustment, only to resort vehemently to the heavy hand of central control when Bubbles begin to falter.
Chinese officials appear more serious this time – though markets have over years become accustomed to not taking “tightening” measures seriously. Beijing’s policy approach has been incongruous. They’ve employed various measures to tighten mortgage lending. More recently, officials have attempted to rein in “shadow” lending and some of the more conspicuous areas of financial excess (i.e. insurance and global M&A). At the same time, from a macro level Beijing has promoted the ongoing rapid money and Credit growth necessary to meet official GDP targets. To be sure, efforts to restrain Bubbles and systemic risk while spurring massive monetary inflation were never going to end successfully.
Repeating the above quote from BofA China economist Helen Qiao: “Policy makers will likely seize this rare opportunity to reduce leverage in the economy in a deeper, longer and more thorough campaign.” And from JPMorgan economist Zhu Haibin: “Focusing on cutting excess leverage in real economy, instead of in the financial sector came as a surprise to some…” Well, at this point, Chinese officials are confronting a harsh reality: there are few alternatives left. Systemic risk has only mushroomed in spite of myriad tightening measures and policy approaches.
China is on course for $3.5 TN of Credit growth this year – with a trajectory that is as precarious as it is unsustainable. If they do in fact take the necessary more systemic approach to containing Credit excess, it’ll be a new ballgame in China and globally. Yet at this point officials are not taken seriously. That officials did not act with more resolve in previous tightening attempts creates the dilemma that only harsh measures will now suffice. Global markets met President Xi and other’s pronouncements this week with a giant yawn. The expectation is that dramatic measures will not be imposed prior this autumn’s Communist Party National Conference.
I’m reminded of the Rick Santelli central banker refrain, “What are you afraid of?” Yellen and Draghi seemingly remain deeply concerned by latent market fragilities. How else can one explain their dovishness in the face of record securities prices and global economic resilience. A headline caught my attention Thursday: “Bonds: ECB Gives ‘Green Light’ to Summer Carry Trades, BofA says.” It’s been another huge mistake to goose the markets this summer with major challenges unfolding this fall – waning central bank stimulus, Credit tightening in China and who knows what in Washington and with global geopolitics.Subscribe to NFTRH Premium for an in-depth weekly market report, interim updates and NFTRH+ chart and trade ideas; or the free eLetter for an introduction to our work. You can also keep up to date with plenty of actionable public content at NFTRH.com. Or follow via Twitter @BiiwiiNFTRH, StockTwits or RSS. Also check out the quality market writers at Biiwii.com.