Contemporary Finance’s Defect

By Doug Noland

October 3 – CNBC (Jeff Cox): “Federal Reserve Chairman Jerome Powell said the central bank has a ways to go yet before it gets interest rates to where they are neither restrictive nor accommodative. In a question and answer session Wednesday with Judy Woodruff of PBS, Powell said the Fed no longer needs the policies that were in place that pulled the economy out of the financial crisis malaise. ‘The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore… Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral… ‘We may go past neutral, but we’re a long way from neutral at this point, probably.'”

Market bulls grimaced. Powell: “We may go past neutral, but we’re a long way from neutral at this point…” CNBC’s Jim Cramer called it “amateurish.” Chairman Powell was certainly candid, something shockingly unusual for a Fed chair. So atypical was his candor, the Chairman was misconstrued as a novice unschooled in the art of modern central banking.

The bottom line is the Fed waited much too long to begin normalizing monetary policy. Moreover, they pre-committed to an extremely gradual path of rates increases. This policy approach essentially ensured that so-called “tightening” measures would fail to tighten financial conditions. Over-liquefied and speculative markets were content to look right through them, confident that cheap liquidity and easy Credit conditions would run unabated. Clearly, stock gains in the multiple thousands of basis points easily counteracted a couple hundred basis point increase in short-term borrowing costs.

I’ll add that this issue of a so-called “neutral” rate only confused the issue. What Fed funds target rate would be just right, neither stimulating nor restricting? Well, in this age of market-based finance, market dynamics have a profound effect on economic performance. “Risk on” in the marketplace ensures strong wealth effects, readily available cheap finance for spending and investment, and easy Credit Availability (throughout the economy) more generally. On the other hand, “Risk Off” would see a tightening of financial conditions, tighter Credit, diminished perceived wealth and more restrictive spending and investing.

Perhaps there’s a view that a “neutral” policy would be a target rate that balances “Risk on” and “Risk Off.” In a policy paper perhaps, but that’s not the way markets function in the real world. In reality, if financial conditions remain too loose for too long, powerful Speculative Dynamics take hold. And once inflation psychology takes deep root in the asset markets, the commanding spell will be broken only from the shock of much tighter financial conditions and painful losses. “Housing prices only go up.” “Buy and Hold. Stocks for the long-term.”

There’s further pertinent monetary policy analysis. Back in 2013, chairman Bernanke resorted to “the Fed will push back against a tightening of financial conditions.” It received little attention at the time, but it was a fateful declaration. The backdrop was one where the Fed had employed extraordinary policy measures, inflating securities markets as its primary post-crisis stimulus mechanism. It was Bernanke paddling ever deeper into uncharted waters, explicitly signaling to the markets that the Federal Reserve was ready to respond to an equities market pullback with additional monetary stimulus. This was a game changer for market perceptions and played a major role in exacerbating Bubble Dynamics.

For years now, markets have been operating under the presumption that the Fed would immediately pull back from “normalization” in the event of fledgling risk aversion and/or stock market weakness. Chairman Powell on Wednesday afternoon threw the proverbial monkey wrench into this central market perception.

September’s 3.7% Unemployment Rate was the lowest since December 1969. Year-over-year Average Hourly Earnings came in at 2.8% and are poised to soon surpass 3% for the first time since April 2009. The ISM Non-Manufacturing Index jumped three points to the strongest reading since August 1997. The ISM Employment component surged almost six points to 62.4, the highest level in data going back to 1997.

Federal Reserve Bank of Chicago president Charles Evans (on Bloomberg TV): “I think that my own take on a neutral longer run funds rate is 2.75%. So, I think getting policy up to us slightly restrictive setting, 3%, 3.25% would be consistent with the strong economy and good inflation that we’re looking at.”

When even the most perennially dovish Federal Reserve president uses the word “restrictive” and discusses taking the Fed funds up another 100 bps, one has to take notice.

It took a while, but central bankers have become less complacent with respect to inflation risks. For too long they have been fixated on deflation, in spite of the greatest securities and asset market inflation the world has ever experienced. Clearly, the Fed didn’t see a 3.7% unemployment rate coming. More importantly, they never anticipated massive late-cycle fiscal stimulus. A booming economy and Trillion dollar deficits? No way. Way.

They were blindsided by the rise of tariffs and protectionism. To be sure, the Fed today has no way to gauge the economic and inflationary consequences associated with a prolonged trade war with China. Rather suddenly, there’s a murky future out there that has Fed officials fretting inflation making a dazzling revival on their watch.

All of a sudden, 2% short rates seem incongruous with a booming economy, rising price pressures and the risk of a trade-related inflationary shock. And if central bankers are now on edge, markets better be on edge. This is new and awkward. But what about faltering EM and slowing global growth? All the overcapacity in China and globally?

Well, there is now a not unlikely scenario of faltering markets concurrent with some stubborn inflationary pressures. The GSCI commodities Index was up another 1.7% this week, with WTI jumping past $74. Confidence that any tightening of financial conditions (i.e. weak equities) would be met with resolute measures from the Fed (and global central banks) is increasingly dubious. Ten-year Treasury yields jumped this week to highs since 2011.

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 the 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 would 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, with the GSE’s transferring these funds to the MBS 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 (with deleveraging). Yet rather than addressing what went so terribly wrong in 2008, 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 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 throughout 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 this 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 sales proceeds 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) one-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 for purchasing 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 back 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 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.

Let’s begin at the “Periphery.” A period of relative EM instability came to an end. The South African rand sank 4.3% this week, with the Chilean peso down 3.0% and the Colombian peso falling 2.0%. Asian currencies were under notable pressure, with the South Korean won down 1.9%, the Indonesian rupiah 1.8%, the Indian rupee 1.7%, and the Thai baht 1.6%. The Russian ruble declined 1.6%, the Polish zloty 1.3% and the Turkish lira 1.3%. As for major equities indices, stocks in both Turkey and India sank 5.1%. Equities fell 4.4% in Taiwan and 3.7% in South Korea. Argentine stocks sank 9.8%, with Mexico down 2.9%.

As much as currencies and stocks were under pressure, the more ominous EM moves were in bond markets. Ten-year (local) sovereign yields surged 33 bps in Indonesia, 26 bps in Russia, 21 bps in South Africa, and 14 bps in Hungary. Dollar-denominated EM debt provided no safe haven. Venezuela’s 10-year dollar yields surged 70 bps to 38.55%; Argentina’s 64 bps to 9.90%; and Turkey’s 52 bps to 7.86%. Ten-year dollar yields jumped 19 bps in Indonesia, 19 bps in Chile, 18 bps in Russia, 17 bps in Mexico and 14 bps in Colombia.

How were markets faring at the “Periphery of the Core”? Italian 10-year yields surged another 28 bps to 3.42%, the high going back to March 2014. Italian bank stocks were hit another 4.7%, bringing 2018 losses to 19.2%. Contagion saw Greek yields jump 33 bps to 4.45%, with Greece’s major equities indices down 5.0%. European bank stocks fell another 1.9% this week. Equities indices were down 2.4% in France and 2.6% in the UK. UK yields jumped 15 bps to the high since January 2016.

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.

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