lunes, 4 de noviembre de 2013

lunes, noviembre 04, 2013

The May/June Dynamic

by Doug Noland

November 1, 2013

 

Keenly monitoring the periphery of the periphery.


From Q&A: “In the spirit of simple questions, you’re spending a Trillion dollars a year on this asset purchase program…” 

Federal Reserve Bank of St. Louis President James Bullard: “It’s worse than that.  We’re manufacturing it out of the blue.”

Continuation of question:  “That’s my question.  Where does that money come from?  And given that it’s presumably our moneytaxpayer moneyshould we be troubled that then half of it is going to prop up government spending, which is also our money?”

Bullard“We’re creating the money So you’ve got a Treasury bond and I (the Fed) want to buy it.  So you have an account with me at the Fed, so I Credit your account and buy your piece of paper.  So what that does is that increases base money which is reserves held at the Fed That’s your account with meplus all the cash that’s out there circulating.  So that’s the monetary base and the monetary base is off the chartsabsolutely off the charts.  The monetary base by itself doesn’t create inflation. 

It’s only when that starts becoming money and circulates out in the economy And the St. Louis Fed is famous for looking at different measures of the money supply M1, M2, all that stuffThose measures of the money supply have not gone off the chartsSo, where’s the missing linkWhat has happened is that the banks have a lot of reserves but they are perfectly content to just leave them at the Fed – and they’re not turning around and making a lot of loans. If they do turn around and start making a lot of loans, money supplies will go up dramatically.  And, presumably, if that goes on for too long, that will lead to a lot of inflation.  So that’s the conventional story about why this is so dangerous in creating inflation However, the truth – the empirical matter is – over the last five years these central bank balance sheets have been very large and that lending process has not gotten going.

The money supplies have not been ramping up and you have not seen inflation. In fact, inflation has stayed at low levelsInflation is close to 1.2% on our headline inflation measure per PCE [personal consumption expenditure] right now.  So it’s very low and it’s below our 2% inflation target…  So the inflation hasn’t materialized.  And, believe me, I’m the biggest inflation hawkThat’s how I grew up and I came out of the St. Louis Fed research department and I’m at the North Pole of inflation hawks.  But that isn’t the problem we’ve had, so far.”  Federal Reserve Bank of St. Louis President James Bullard, November 1, 2013, speaking in St. Louis. 

The conventional view holds that massive QE has not caused inflation because the Fed’s monetary fuel has remained unused as “reserves” on bank balance sheets. From this viewpoint, inflation risks lurk somewhere out in the futurewhen the banks eventually lend thesereserves” and the monetary fuel finally makes its way into the real economy Moreover, the optimistic view holds that the Fed has the tools to adeptly manage any future inflation issue.

I take a much different view. QE is anything but benign.  The Fed’s monetary fuel certainly doesn’t just sit inertly on bank balance sheets. Indeed, this monetary inflation is immediately unleashed upon the financial markets, with the newly createdmoneysetting off a chain-reaction of transactions, flows and market impactsOver time, this dynamic foments huge distortions in marketplace liquidity, risk perceptions, speculative financial flows, asset prices and market stability.  And, somehow, when Fed officials discuss QE they avoid any mention of what have become conspicuous inflationary effects on securities prices.

Fundamentally, the repeated injection of Fed liquidity over time – and especially at key junctures - into the financial markets has created Bubbles increasingly vulnerable to even subtle changes in market perceptions and/or changes to the risk-taking and speculative leveraging backdrop. This is the essence of the so-calledaddiction induced by the Fed’s historic monetary inflation.

I continue to believe the May/June period marked an important inflection point in global Credit and asset market Bubbles. Latent market fragilities – including QE dependenciesturned widely evident, forcing both the Fed and Chinese to back-peddle from their planned somewhat less accommodative policy stance. And, in both cases, respective Bubbles bounced right back more powerful than ever. Still, I believe the spring period marks the initial bursting of a historic Bubble throughout the “emerging markets” (EM) – at the “periphery” of the “global government finance Bubble”. And while speculative flows have returned to EM in recent weeks, I believe this has only temporarily masked what will remain ongoing financial and economic fragilities
 
Rising Treasury yields (falling prices) in the face of EM instability was integral to May/June market fragility. In short, the disappearance of Treasury safe haven status caught the marketplace by surprise. After accumulating Trillions of international reserves over recent years, the reversal of “hot money” and other speculative flows saw EM central banks selling Treasuries (and other reserve assets) as part of efforts to support their faltering currencies.  This dynamic was instrumental in what was emerging as a problematic global jump in market yields.
 
Myriad methods of leveraged speculation, including popular so-calledrisk paritystrategies, were performing poorly with heightened risk of a problematic reversal of flows. Suddenly, the risk of leveraging fixed income securities appeared much higherMoreover, the capacity for leveraged holdings of Treasuries and fixed income to hedge against risk market exposures appeared much diminishedSignificant market losses and a reversal of flows out of the leveraged speculating community was a real possibility.  However, confidencealong with speculative inflows - was restored when the Bernanke Fed stated it was willing to even increase the size of QE to “push backagainst any tightening of financial conditions.

This week was somewhat reminiscent of the early-days of the May/Junerisk offmarket dynamic. EM bonds and currencies were under some pressure, while Treasury yields jumped.  The U.S. dollar abruptly caught a bid and commodities were hit hard. As for EM currencies, the Hungarian forint declined 4.1%, the South African rand 3.6%, the Indonesian rupiah 2.8%, the Czech koruna 2.9%, the Brazilian real 3.0%, the Policy zloty 2.7%, the Bulgarian lev 2.3%, the Romanian leu 2.2%, the Chilean peso 2.0%, the Russian Ruble 1.8% and the Turkish lira 1.7%. On the EM bond front, Indonesian 10-year yields jumped 67bps to a 7.76%South African yields rose 35 bps to 7.78%Brazilian 10-year yields gained 35 bps to 11.88%, and yields in Mexico jumped 35 bps to 6.09%Turkish 10-year yields jumped 37 bps to 8.81%. 

The CRB Commodities index this week dropped 2.7% to a 15-month lowFrom a Bubble analysis perspective, this week saw the reemergence of some risk-aversion at the “periphery” of the “periphery.” Perhaps it was only market noise. But, then again, this is precisely where I would expect a more general marketrisk offdynamic to initially materialize. 

There’s a decent case to be made that the reemergence of the May/June Dynamic could prove surprisingly problematic for the marketsAfter all, the “all’s clear” - “no tapertill March or even June” - siren has been blasted, perhaps erroneously. The market over recent months has given 1999 excesses more than a run for their money.

With only two months to wrap up a potentially historic market year, the calendar may prove an issue.  Of course, the widely anticipated melt-up into year-end scenario remains a possibility. The markets surely could turn wildly volatile and gameyYet, at this point, an unexpected sharp downside reversal would be the proverbialpain tradecatching the complacent crowd extraordinarily exposed.  

The global leveraged speculating community would appear particularly susceptible to year-end performance dynamics. Funds that have posted big years might move aggressively to lock in 2013 gains and ensure huge paychecks.  At the same time, there are an unusually large number of funds struggling with lackluster performance despite the big year in equities. When the Fed backtracked on tapering, even the most cautious had little alternative but to jump aboard the equities melt-up.  This creates a backdrop of unstable markets and a bevy of potentiallyweak-handedtraders and portfolio managersScores of funds would likely have low tolerance for losses, creating the possibility for a mercurial market backdrop.  I suspect many view the current market environment as an accident in the making.

The Fed’s taper reversal incited a significantly more speculative equity market dynamic. To be sure, trend-following and performance-chasing trading shifted into high gear. The hedge funds and market speculators threw caution to the windEquities, and U.S. stocks in particular, became the speculative vehicle of choice. And even mutual fund flows, fearful of losses in EM, bonds and municipal debt, turned strongly in favor of perceived U.S. equities market stability.  In what has become a typical market Bubble Dynamic, the first major crack at the “periphery” (EM) provoked a policy response that exacerbated dangerous excess at the “core” (i.e. U.S. stocks and corporate debt).

It’s worth noting that between June 24th trading lows to this Wednesday’s intraday highs, the small cap Russell 2000 gained 19.2% (increasing y-t-d returns to almost 35%). This period saw a major short squeeze, highly speculative trading activity and the type of market capitulation and exuberance consistent with a major market topping processTesla almost tripled in three months, while Netflix gained over 80% from June lows.

The Fed’s failure to begin tapering in September will come back to bite. Already highly speculative markets became only more vulnerable and Bubble Dynamics only more conspicuous.  This week from BlackRock’s Larry Fink:  “It’s imperative that the Fed begins to taper.  We’ve seen real bubble-like markets again. We’ve had a huge increase in the equity market. We’ve seen corporate-debt spreads narrow dramatically.” 

Federal Reserve Bank of Philadelphia President Charles Plosser made notably cautious comments Friday on CNBC. “I think many people - myself included – I’m not alone in this - are beginning to worry about the consequences of how we unwind ourselves from all this stuff… It’s not because that we know what’s going to happen. It’s because unintended consequences or the build-up of risks can be very important. I think we have to balance, not just the risks in the economy, but our own risks that we’re creating down the road.”  And in music to my ears, Mr. Plosser spoke of the need to take some discretion away from the Fed and of making policymaking moresystematic.” He admitted to being dumbfounded by the FOMC’s move to $85bn monthly QE, and said the hurdle to increase QE would be “very high.”  
   
There is growing acceptance that the Fed has gone too far with its experimental policymaking – and the costs associated with overheated markets are mounting.  In the “old days, there was appreciation for the risks associated with a diffident central bank finding itselfbehind the curve.”  The essence of the analysis was that if the Fed were slow to tighten, our central bank would eventually face cumulative excesses and the need for more aggressive tightening measures.  And while the Fed has removedtightening” from its vocabulary, the analytical premise remains valid:  With monetary policy having remained ultra-loose for way too long, the risks associated with cumulative excesses have begun to expand rapidly.  The Fed doesn’t have until March or June to start winding down increasingly destabilizing QE.

Q&A:  What do you think is the biggest unintended consequence of QE?

Federal Reserve Bank of Richmond President Jeffrey Lacker:Which one? That’s just to buy me some time. I think one of the underappreciated, perhaps, consequences of QE has been the sense it’s given rise to that the central bank has responsibilities for real outcomesreal economic growth outcomes. I think the effect of monetary policy on real growth is – except for just us avoiding disastersas long as we are at reasonably close to appropriate policy, I think our effects are modest and transitory.  So the idea that we can have a sustained effect on the unemployment rate at a horizon of a couple of years I think is an unfortunate consequence of the degree to which we’ve conducted policy seemingly motivated by the desire to do what we can for the labor market.” (November 1, 2013)

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