(NO) CONUNDRUM 2.0 / PRUDENTBEAR.COM

(No) Conundrum 2.0

Doug Noland

May 9, 2014 


Could things possibly be any more fascinating?

Representative Kevin Brady: “I’ll conclude with this. My main concern, having served on the committee in the early to mid-2000s, your able and very highly respected predecessor sat where you sat and assured the committee that maintaining low interest rates for an extended period wouldn’t cause general price inflation or inflate an unsustainable asset bubble - which didn’t prove to be the case. After the credit-fueled housing bubble burst in 2007, your predecessor assured the committee that the resulting weakness would be confined to the subprime segment of the housing market and the damage would be limited to about $150 billion, roughly the cost of the S&L crisis. Following the financial crisis in the fall of 2008, we were repeatedly assured the Fed had the strategy to exit from the large expansion of its balance sheet to normalize monetary policy, including the federal funds target. Yet, the goalposts have been moved time and time again - and now removed. And today, you’ve assured the committee once again - and I so appreciate your testimony - that the Fed is confident it can exit without sparking high inflation; but that we can’t know the details or the time-table; but that the Fed and the FOMC have it essentially handled. I don’t expect the Fed to be perfect. Yours is a tough job. Theirs is a tough job. But it just strikes me this over time “don't worry be happy” monetary message isn’t working - at least, in my view, for the committee and certainly not for the economy at this point. I know my colleagues will ask about today’s Wall Street Journal where noted economist, Federal Reserve historian Dr. Alan Meltzer, makes the point never in history has a country financed big budget deficits with large amounts of central bank money and avoided inflation. My worry is that the track record of central banks, including the Fed, in identifying these economic turning points and acting quickly to prevent inflation, that track record is not as good as we would like. So, forgive me for being skeptical. I believe we need more specifics and a clear timetable on the comprehensive exit strategy.”

Good luck with that, Congressman. There will be neither specifics nor a timetable. The Fed has pretty much painted itself into a corner. QE3, in particular, fueled dangerous Bubbles in equities and corporate Credit. Meanwhile, it ensured another two years of global (largely Asian) over- and mal-investment. Today and going forward, the Fed will have little clarity as to the soundness of the financial markets or real economy. It will have minimal grasp on prospective inflation rates. So long as the financial Bubble inflates, economic output will appear OK. Yet market Bubbles guarantee intractable financial and economic fragility. Market tumult would, in short order, darken economic prospects. Very few appreciate today’s dilemma.

May 8 – Bloomberg (Simon Kennedy and Ilan Kolet): “The global economy is rebooting for ‘Great Moderation 2.0.’ Barely five years after the worst financial turmoil and recession since the Great Depression, the U.S. and fellow advanced nations are showing a stability in output growth and hiring last witnessed in the two decades prior to the crisis, in an era dubbed the ‘Great Moderation.’ The lull points to a worldwide economic expansion that will endure longer than most. Volatility in growth among the main industrial countries is the lowest since 2007 and half that of the 20 years starting in 1987… Investors also are becalmed, with a risk measure that uses options to forecast fluctuations in equities, currencies, commodities and bonds around the weakest level in almost seven years… Such calm finally is providing a support for equities over bonds and giving companies and consumers long-sought clarity to spend.”

What an incredibly fascinating time to be a “top down” analyst – of economics, global markets and geopolitics. And as an analyst of Bubbles, these days it’s too often “Déjà vu all over again.” “Tech Bubble 2.0” resonates. “Great Moderation 2.0” analysis, well, it suffers from the same misconception as the original: complete disregard for the impacts and future consequences of flawed policies and resulting Credit and asset Bubbles. With going on six years of unprecedented growth in Federal Reserve Credit and global central bank holdings, analysts should be especially cautious when it comes to extrapolating the deceptive appearance of financial and economic stability.

From an analytical perspective, I’ll dismiss “Great Moderation” chatter and focus instead on the reemergence of “Conundrum.” Recall that chairman Greenspan introduced “Conundrum” into market lexicon back in 2005. Confounding the Federal Reserve (officials and models), long-term yields trended lower in the face of Fed rate increases.

From my perspective, there was No Conundrum in 2005. I addressed this topic in a May 2005 CBB, “Conundrums,” and again in June 2006 with “No Conundrum, Again.” The Fed had increased short-term rates from 2% to 4% between December 2004 and November 2005 with minimal impact on long-term Treasury yields or mortgage rates. I saw no mystery. Committing another major policy blunder, the Fed had held rates too low for too long. And in the midst of an increasingly speculative Mortgage Finance Bubble backdrop, timid Fed rate increases completely failed to restrain leveraged speculation. Financial conditions were remaining extraordinarily – dangerously - loose.

I want to bring in some data. Mortgage Credit growth averaged about $270 billion annually during the decade of the nineties (no slouch period for Credit growth!). Total Mortgage debt began growing at doubled-digit rates in 2002 as the Fed aggressively reflated (post-“tech” Bubble). Surging annual mortgage debt growth surpassed $1.0 Trillion for the first time in 2003. It then inflated to $1.27 Trillion in 2004 and hit an all-time record $1.45 Trillion in 2005.

It was my view at the time that long-term Treasuries, agency debt and MBS were beneficiaries (downward pressure on yields) of an increasingly unstable Bubble backdrop. Essentially, the marketplace was discounting the unsustainability of both rapid system Credit growth and an unsound economic expansion. Indeed, I argued at the time that this dynamic was dysfunctional. In a key “Terminal Phase” Bubble Dynamic, liquidity and general speculative excess sustained the mispricing (and gross over-issuance) of mortgage Credit and prolonged the general Bubble period.

At the end of the day, one could say bond prices had it “right” and stocks had it “wrong.” It’s so good to be a bond. During the Bubble period, low bond yields spurred destructive excess that came back to crash stocks – while the inevitable bust proved absolutely delightful for Treasuries and agency securities.

So I am monitoring the 2014 decline in Treasury and global sovereign yields with keen interest. Of late, there’s been some concern that declining long-term yields might be signaling issues thus far ignored by bullish equities investors (with the S&P500 a smidgen below record levels). From my experience, the bond market tends to be a much more effective discounter of fundamental prospects (and macro inflection points!) than equities. For sure, equities tend to turn wild late in the speculative cycle. It’s worth noting that 10-year Treasury yields traded to almost 5.30% in June 2007 and then sank almost 150 basis points in five months – while the S&P 500 defied a faltering Bubble to trade to record highs in October 2007.

After ending 2013 at 3.03%, 10-year Treasury yields have declined 41 bps y-t-d. Sovereign yields have collapsed throughout Europe and have generally retreated around the globe. What’s behind the decline? Are there potential ramifications for stocks and the global economy? These are critical questions, especially considering the bullish consensus view of accelerating U.S. and global growth.

Some thoughts. First of all, I’m rather convinced that we’re in the “Terminal Phase” of the global government finance Bubble that began inflating more than five years ago. Credit and speculative excesses have exacerbated global distortions – including problematic wealth distribution and economic maladjustment (certainly including mounting over-capacity for too many things). For now, there are some disinflationary tailwinds exerting modest downward pressure on consumer price aggregates. Bond prices are supported by meager CPI gains throughout the developed world. I believe “safe haven” government debt markets are further supported by the unsustainability of various Bubbles, certainly including U.S. stocks, corporate debt and global risk assets more generally.

It’s also my view that a rapidly deteriorating (faltering global Bubble-induced) geopolitical backdrop has begun to bolster safe haven demand for Treasuries and sovereign debt. I fear the “Ukraine” crisis marks an unfortunate end to an era of general global cooperation and integration – and the troublesome return of “Cold War” tensions and risks. Myriad risks encompass economic, financial and military. And it is difficult for me to envisage rapidly escalating tensions in the South China Sea and East China Sea as mere coincidence. Russian and Chinese governments appear determined. Both seem to be implementing plans – replete with belligerent war-time propaganda and disinformation. The U.S. is portrayed as the villain – and things seem headed in the direction of an acrimonious bipolar world. There are major potential economic ramifications that go neglected in the midst of bull market exuberance.

I will not claim to be an expert in geopolitics. My macro expertise is more in the realm of Credit, financial flows, Bubbles and associated financial and economic fragility. But these days I discern an extraordinary interplay between geopolitical and the markets. If I’m on the right track with the geopolitical, the world is quickly becoming a more dangerous place. Geopolitical risks compound the vulnerabilities associated with mounting “Terminal Phase” Bubble excesses.

Egregious Fed and central bank monetary inflation has ensured mispricing for tens of Trillions of dollars of financial assets. In particular, I fear central bank policies have incentivized enormous amounts of speculative leverage (certainly including myriad “carry trades”). This means the leveraged speculator community is once again a source of major instability. And I fear the ETF complex – having doubled in size in four years – is another avenue of potential fragility. As I’ve posited previously, a strong case can be made that the scope of trend-following and performance-chasing finance currently fueling market Bubbles is unprecedented. The consensus view dismisses the notions of speculative excess, Bubbles and fragility.

And here’s where things get really interesting. Whether things blow up soon or not (in Ukraine or the China Seas), newfound geopolitical uncertainties have unexpectedly elevated market risk. I believe the more sophisticated market operators have likely begun to take some risk off the table. De-risking/de-leveraging wasn’t much of an issue when the Fed was adding $85bn of monthly market liquidity. But with the Fed now in the waning months of its QE operations, the markets are increasingly susceptible to a bout of “risk off.” If the hedge funds are turning more risk averse, this would likely mark an impending inflection point in terms of overall marketplace liquidity.

I suspect the markets have already entered a period of unusually high risk. What the bulls see as “healthy rotation,” I view as confirmation of incipient risk aversion, greed transforming to fear, and the overall “inflection point” thesis. With QE winding down, there is impetus for the leveraged speculators to push forward with de-risking while Fed liquidity remains available. Bullishness is so entrenched that any serious market retreat would catch most by surprise. A scenario where the hedge funds bound for the exits as a spooked public clicks the sell button on ETF holdings doesn’t these days seem like such a longshot.

Yet I over-simplify things. The geopolitical backdrop has surely turned incredibly complex and nuanced. I believe Russia and China have increasingly serious issues with U.S. dominance over global finance. Both have serious domestic problems that might incentivize them to act out – and perhaps even act out as partners.

At the same time, the U.S. and the West are hoping financial and economic sanctions (as opposed to military confrontation) will alter Putin’s behavior. A weak ruble and faltering Russian stocks and bonds are seen as pressuring Putin and his inner circle. As things unfold, I would expect officials from Russia and China to demonstrate resolve of steel against Western pressure (financial and otherwise). And it would seem reasonable that the performance of Western stock and bond markets now also plays into the new Cold War calculus. It would appear an especially inopportune time for a bout of serious market tumult. From a game theory perspective, perhaps this even reduces the odds of a near-term market blowup. Personally, I wouldn’t want to bet on stability.

It was another interesting week in the markets. In the category “careful what you wish for,” Mr. Draghi finally seemed to get some traction with a weaker euro. The euro declined 1.1% against the yen this week to the lowest level in two months. It is worth recalling that euro weakness versus the yen back in late January corresponded with a fleeting bout of market “risk off.” How big is the yen carry trade – borrowing in cheap yen to speculate in higher-yielding European stocks and bonds? Might this be an important trade that risks pushing the leveraged players into a more urgent de-risking/de-leveraging mode?