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| Etiquetas: Central Banking, Credit Bubbles, Depression, Derivatives, Economics, Financial Markets, Investment Strategies, Liquidity Trap, World Economic And Political

Unfolding Instability Thesis

Interestingly, financial crises over the ages have often unfolded during autumn. Early economic thinkers pondered and debated the sources of instability and the root cause of recurring economic cycles. Even in relatively primitive economic systems, money and Credit played a leading role. I admit to finding "trade cycle" analysis intriguing. Even in a simple agrarian economic structure, farmers would borrow for the spring planting season and repay loans later in the fall. This Credit Cycle played prominently, with monetary abundance and associated economic boom in the spring and summer followed by tightening and vulnerability as bank lending books contracted after harvest.

Trade cycle and monetary analysis from the British economist Ralph Hawtrey (1879-1975) has over the years resonated:

"The general rise of prices will involve a proportional increase of borrowing to finance a given output of goods, over and above the increase necessitated by the increase in output. This increase of borrowing, meaning an increase in the volume of credit, will further stimulate trade. Where will the process end? In the case of the curtailment of credit the self-interest of the bankers and the distress of the merchants combined to restore the creation of credits…but in the case of the expansion of credits there is no such corrective influence at work. An indefinite expansion of credit seems to be in the immediate interest of merchants and bankers alike. The continuous and progressive rise of prices makes it profitable to hold goods in stock…thus the merchant and the banker share between them a larger rate of profit on a larger turnover... The greater the amount of credit created, the greater will be the amount of purchasing power and the better the market for the sales of all kinds of goods. The better the market the greater the demand for credit. Thus an increase in the supply of credit itself stimulates the demand for credit…" (Hawtrey, "Currency and Credit").

"Mr. Hawtrey's theory explains why there were not merely small oscillations around the equilibrium, but big swings of the pendulum in the one or the other direction. The reason is the cumulative, self-sustaining nature of the process of expansion and contraction. The equilibrium line is like a razor's edge. The slightest deviation involves the risk of further movement away from equilibrium…the expansion could go on indefinitely, if there were no limits to the increase in the quantity of money" (Gottfried Haberler, "Prosperity and Depression").

In Hawtrey's analysis, "dealers" borrowed to finance inventories of goods and commodities. This borrowing activity created the marginal monetary flow and purchasing power within the economic system. Credit flows were fundamental to the monetary forces sustaining the economic cycle. Hawtrey appreciated that Credit and the "flow of money" was inherently self-reinforcing, hence unstable. During upcycles, Credit begets additional Credit; monetary excess begets further destabilizing excess. Eventually, the monetary expansion comes to an end and a painful downside to the cycle becomes unavoidable. At least that's the way it used to work.

Hawtrey would find today's financial architecture unrecognizable: unfettered finance on a global basis; near zero and even negative interest rates; open-ended QE and ballooning central bank balance sheets; central bank manipulation of bond yields and asset prices; highly leveraged securities holdings and a derivatives marketplace to the tune of hundreds of Trillions.

While Hawtrey's "dealers" were financing goods inventories, contemporary "dealers" - the central banks, hedge funds and leveraged speculators, derivatives operators, GSEs, etc. - finance inventories of securities. Instead of banks (restrained by reserve and capital requirements) lending against goods inventories, boundless global "money" markets finance unfathomable speculative securities holdings. Going back now at least 25 years, the financing of securities holdings has been the marginal source of liquidity fueling recurring asset Bubbles and economic cycles. This monetary structure has been acutely unstable. Over time, worsening instability fostered increasingly intrusive central bank command over the cost of finance, marketplace liquidity and securities market pricing more generally.

Audience question from a Friday panel discussion at a Swedish Riksbank event: "Imaging you're traveling into the future - 25 years. What would you expect to receive when you are evaluated 25 years into the future regarding the present period of unconventional policy methods?"

Bank of England governor Mark Carney: "Great question to ask. Terrible question to answer… Those who are marking our exam papers will start with our objectives. And we'll see how well we achieved our objectives. So, starting with whether we've achieved our inflation target and, subject to that, reduced unwarranted volatility in output and employment. And the steps we have taken on the financial side - the effectiveness of those will be revealed by 25 years down the road. They will have been properly tested in a way that, obviously, everyone in this room cannot truly mark that exam paper right now."

I doubt future analysts and historians looking back in 25 years will have much interest in whether inflation targets were achieved or policy effects on unemployment rates and GDP. Contemporary central bankers will instead be judged by the impact a decade plus of extreme monetary measures had on Financial Stability. Sure, unprecedented monetary stimulus reflated securities markets, asset prices, perceived wealth and economic activity. But did it nurture sustainable financial stability - or instead only create more systemic and perilous global financial and economic Bubbles? I believe the answer lies foremost in the global dimensions of speculative leverage.

My view holds that prolonged experimental policy stimulus has been a boon for global securities leveraged speculation. The scope of today's Bubble is unprecedented; the monetary role of securities finance upon the maladjusted and unbalanced global economy unparalleled. The Bubble in EM has gone miles beyond 1997. The Bubble in China is truly epic. I suspect a staggering amount of "carry trade" leverage has accumulated globally over this protracted speculative cycle. ECB policies have clearly spurred leveraged speculation throughout euro zone bond markets, especially the unsound periphery. Eastern Europe as well? There is surely massive leverage in U.S. Credit, most likely having played a prevailing role in the booming investment-grade corporate marketplace.

We're in the stage of the cycle where things look good. In the U.S., in particular, the New Era and New Paradigm mentality has taken deep root. The economy appears robust, bolstered by fantastic technological advancement and scientific development. The underlying instability of finance goes unrecognized; the global nature of Bubble Dynamics unappreciated. Meanwhile, markets again this week provided confirmation of the Unfolding Instability Thesis.

Italian 10-year yields surged 23 bps this week to 2.46%, the high since October 2014. In only three weeks, Italian two-year yields have jumped 79 bps to 0.46%. Portuguese 10-year yields rose eight bps this week to 1.95%, a three-month high. Spanish yields traded above 1.5% in Monday trading, the high going back to early March.

This month's almost 70 bps spike in Italian 10-year yields is alarming. I would argue this week's 17 bps drop in German 10-year yields (to 41bps) is more problematic for markets more generally. The Italian to German 10-year yields spread widened 40 bps in just one week. The Portuguese to German spread widened 25 bps this week, with the Spanish to German 10-year spread 19 bps wider. The Italian to German two-year yield spread has widened 78 bps in two weeks.

It was a rough week for those short German bunds (or even French bonds) to finance leveraged holdings in European periphery debt. Pain in this popular (Crowded?) trade follows on the heels of painful losses in various EM "carry trades." The Turkish lira dropped another 4.7% this week. And while Latin American currencies for the most part rallied this week, Eastern European currencies were notably weak. The Hungarian forint dropped 1.5%, the Polish zloty 1.4%, the Czech koruna 1.4%, the Bulgarian lev 1.1% and the Romanian leu 1.0%. How much leveraged has accumulated in higher-yielding European EM debt?

After trading at 3.08% in Tuesday trading, 10-year Treasury yields reversed course and closed the week down 12 bps to 2.93%. Minutes from the early-May FOMC meeting were released Wednesday afternoon. The minutes were generally viewed as dovish, with the Fed tolerant of inflation rising above target and "uncertainty surrounding trade issues could damp business sentiment and spending."

Bond markets have been anxiously anticipating some hint from the Federal Reserve that unstable global markets could slow the path of rate increases. They seemed to discern them embedded in the minutes. The Treasury rally alleviated some off the selling pressure on EM bonds. At the same time, the upheaval in Italian and European debt markets appeared a significant escalation in global de-risking/de-leveraging dynamics. Sentiment with respect to global economic prospects has begun to deteriorate.

Japan's Nikkei stock index dropped 2.1% this week, and the Shanghai Composite fell 1.6%. A paralyzing truckers' strike in Brazil further eroded sentiment. Brazilian stocks sank 5.0% this week. European equities were under pressure as well. Italian stocks sank 4.5%, and Spanish stocks fell 2.8%. European banks were slammed 4.1%, led by an 8.1% drop in the Italian bank index. Japan's Topix Bank index fell 4.1%, and Hong Kong's Hang Seng Financials were down 1.7%. U.S. stocks outperformed, not unhelpful to the rising dollar (up 0.7% this week). Curiously, crude was slammed 5.3%, most of the losses coming late in the week.

The euro dropped 1.0% this week to the lowest level since last November, adding fuel to the destabilizing dollar rally.

May 23 - New York Times (Jason Horowitz): "The populist parties that won Italy's elections two months ago by demonizing the political establishment, the European Union and illegal migrants in often vulgar terms were granted the go-ahead… to form a government, crystallizing some of the biggest fears of Europe's leaders, who were already bracing for turbulence. The rapid ascent of populists in Italy - the birthplace of Fascism, a founding member of the European Union, and the bloc's fourth-largest economy - shattered the nation's decades-old party system. It also gave fresh energy to the nationalist impulses tugging at the Continent and moved the greatest threat to the European Union's cohesion from newer member states on the periphery, such as Hungary and Poland, to its very core. After 80 days of arduous talks, President Sergio Mattarella gave a mandate to form a government to the parties' consensus pick for prime minister, Giuseppe Conte, a little-known lawyer with no government experience."

If uncertainties associated with the new Italian government weren't enough, Spain continues to fester.

May 25 - Financial Times (Michael Stothard): "The risk of early elections in Spain rose dramatically on Friday after two opposition parties threatened motions of no-confidence against the government in response to a damning court ruling in a graft case involving members of the ruling People's Party. Spanish stocks fell and bond yields rose after Socialist leader Pedro Sanchez said that he had tabled a vote of no confidence to topple the government. The liberal Ciudadanos party said it would table its own motion if new elections are not called. This comes as dozens of people related to the ruling centre-right PP, including a former treasurer, were convicted on Thursday of a range of crimes related to the use of an illegal slush fund that helped finance party election campaigns between 1999 and 2005… The judge said that the testimony of prime minister Mariano Rajoy and other party officials that they knew nothing was 'not credible'."

On a global basis, risk aversion is taking hold. De-risking/de-leveraging dynamics have gained momentum. Liquidity abundance has begun to wane; financial conditions globally are beginning to tighten. This ensures markets will now assume a different tact with risk. So long as risk embracement and resulting liquidity abundance were commanding global markets, EM and Italian fragilities were inconsequential. The same could be said for vulnerabilities in regions, countries, governmental entities, sectors, corporations and businesses around the globe. Rather suddenly, however, prospects for risk aversion, Credit tightening and illiquidity will have newly mindful markets keen to sidestep the weakened, fragile and sickly. It may at this point be subtle, but it's also quite a sea change.

The past decade of stimulus-induced bull markets has been occasionally interrupted by bouts of "Risk Off." Granted, these spells proved short-lived. Central bankers - through talk and/or more aggressive stimulus measures - quickly extinguished nascent Fear. Most of all, zero rates and massive and unrelenting QE reinforced Greed. And this went on for way too long. Faith in central banking was further emboldened, ensuring an upsurge in speculative leveraging the world over.

My long-held view is that central bank measures to guarantee buoyant and liquid markets in the end ensure a liquidity crisis. The perception that central banks will always backstop liquidity has incentivized a degree of speculative leverage - and resulting monetary flows - that virtually guarantees financial and economic dislocation.

The world is now on contagion watch. More and more, De-risking/Deleveraging Dynamics are encroaching on Greed. The Fed is raising rates, and global central banks are winding down QE. A shrinking pool of new QE liquidity confronts a rapidly expanding pool of speculative holding liquidations.

I don't expect the Powell Fed to turn hawkish. Indeed, if things unfold as I expect the Fed will surely turn more cautious with rate hikes. But I also believe the new Chairman would rather not come quickly to the market's defense. Markets are long overdue for removing the training wheels. Interestingly, John Authers' Friday evening FT article was titled "Lack of 'Powell put' tightens financial conditions." Similar to Italy's debt load, the true status of the Fed (and global central banker) put will be a greater concern now that financial conditions have begun to tighten and asset markets have turned more vulnerable.


| Etiquetas: Europe Economic and Political, Italy, The Euro

Italy’s new rulers could shake the euro

If it were to crash out of the single currency and default, the damage would be huge

Martin Wolf Italy is not Greece. But not all the differences are encouraging. Its economy is 10-times bigger. Its €2.3tn public debt is seven-times bigger; it is the largest in the eurozone and fourth largest in the world. Italy is too big too fail and may be too big to save. The question is whether its new government will trigger such a crisis and, if so, what might follow?

So far markets are only slightly nervous. On Monday, yields on 30-year Italian government bonds were just 220 basis points above German levels, with yields of 3.4 per cent. This is far below peak spreads of 467 basis points and peak yields of 7.7 per cent in 2011. Alas, it could get far worse. (See charts.) According to the European Council on Foreign Relations, in no member state of the EU, bar Greece, did the sense of “cohesion” of individuals with the EU fall more sharply between 2007 and 2017 than in Italy. By the latter year, its ranking on this criterion had tumbled to 23rd of 28 members.

This is not just due to the economic crisis. Between 1997, when the eurozone was launched, and 2017, Italy’s real gross domestic product per head rose 3 per cent — a worse performance than that of Greece. Italians also feel they have been abandoned to cope with their migration crisis largely on their own. Many Italians, in brief, feel semi-detached from the EU. They are also contemptuous of their establishment. This is why an intellectually incoherent government of leftwing and rightwing populists have gained power, the former stronger in the south, the latter stronger in the north — a division explained by sharp regional economic divergences.

This mess is the fault of both Italy and the EU. The latter has failed to achieve target inflation or generate adequate demand. This has made it difficult to achieve necessary post-crisis adjustments in competitiveness. Germany’s refusal to recognise that these are problems has made things far worse. But Italians also failed to understand the necessity of radical economic and institutional reform if Italy is to thrive, especially in a currency union with Germany. It may be too late. The spiral of populism is: unhappy voters; irresponsible promises, bad outcomes; even unhappier voters; still more irresponsible promises; and worse outcomes. The story is not over. It may have just begun.

The Five Star Movement and the League’s common programme contains enough to spark conflict with the EU and the eurozone: higher spending, lower taxes and assaults on eurozone fiscal and monetary rules. Bruno Le Maire, French finance minister, has already sounded the alarm. Matteo Salvini, hardline leader of the League, responded briskly that: “I didn’t ask for votes . . . to continue on a path of poverty, precariousness and immigration: Italians first!” The complacent assumption is that creditors will rule. If the new government were to break the rules, the European Central Bank could not help it. In a clash, financial instability would bring the Italians to heel. But this is only true if the Italians are unwilling to employ the doomsday weapon of default. Non-residents owned €686bn of Italian government bonds (36 per cent) at the end of 2017. Moreover, in March 2018, the Italian central bank owed partners — the Bundesbank, above all — a further €443bn in the “Target 2” system. Today, debtor and creditor positions inside the European System of Central Banks surpass their scale during the crisis of 2012.

If Italy were to crash out and default, the damage could be huge. Yet even this ignores the wider economic, not to mention political, impact. It will be harder to bully Italy than Greece, largely because Italexit is obviously a far more dangerous proposition than Grexit. So what might happen? One possibility is that Giuseppe Conte, the proposed prime minister, will lead a conventional government. Alternatively, the government will back down at the first whiff of gunpowder. But it is also possible that it will persist with its policies, triggering a run on Italian debt and Italian banks. Without ECB support, that could force limitations on the transferability of bank money outside the country or on its conversion into cash. Italy would effectively fall out of the eurozone.

This would be a monstrous crisis. Would the government then back down? Again, probably so. But the damage to confidence might take years to reverse. The Italian economy would lose its limited forward momentum and go into reverse. The flight of capital, people and businesses could be devastating. Given all this, another election might see the emergence of a still more radical government or, at worst, the unity of Italy might come into question.

Would such a long-running Italian crisis be contained in this one country? Again, possibly so.

Yet, in a serious crisis, other countries might be affected. Note that Spain too has increasing debts within the ECB’s Target 2 system. The pressure on the eurozone could become substantial: reform or perish. In 1991, I argued of monetary union: “The effort to bind states together may lead, instead, to a huge increase in frictions among them. If so, the event would meet the classical definition of tragedy: hubris (arrogance), ate (folly); nemesis (destruction).”

Many Italians do blame Europe for their plight. That may be unfair, but it is inevitable, since so many of the decisions that now affect them are made in Europe. The attempt to break out of the straitjacket, for which they have now voted, seems sure to fail. But that will not resolve the crisis. It could even make it worse in the long run. Until Italy regains prosperity, its politics and its place in Europe will stay fragile. Anything can happen.


Buttonwood: Istanbuls and bears

How Turkey fell from investment darling to junk-rated emerging market 

That is why bets of the kind the Professor made almost two decades ago have become so rare.


| Etiquetas: China, Japan, North Korea, Russia, South Korea, The Sea of Japan, U.S. Economic And Political

The Trap in Japan’s National Strategy
 

| Etiquetas: Goldman Sachs, Interest Rates, Savings, U.S. Economic And Political

The Number That Ends This Cycle…Part 2: Goldman Sachs Makes Its Choice

Everyone seems to agree that if interest rates keep rising a recession and equities bear market will ensue. But no one knows where the breaking point is in terms of, say 10-year Treasury yields. So it’s become a topic of debate with a lot of heavy-hitters offering opinions. Yesterday Goldman Sachs weighed in:

Goldman: Don’t worry about rising interest rates until the 10-year yield hits 4%
(CNBC) – U.S. interest rates have shot up to levels not seen in years recently, giving stock investors a new concern. But a Goldman Sachs strategist says it’s not time to worry just yet.

David Kostin, Goldman’s chief U.S. equity strategist, wrote in a note Friday investors should not worry about rising borrowing costs and their effect on stock valuations until the 10-year Treasury yield zeroes in on 4 percent. The benchmark yield traded at 3.07 percent on Monday.

“A rise in interest rates should lead to a fall in equity prices, all else equal. An equity’s value is equal to the present value of a perpetual stream of future dividends, which are highly sensitive to the discount rate,” said Kostin. “However, lower equity prices are not an inevitable consequence of higher interest rates. We expect negative valuation changes if the level of rates approaches 4%.” He also said stock prices could take a hit before that level is reached if rates rise too rapidly.

Yields have been rising as investors fear that inflationary pressures in the U.S. will lead the Federal Reserve to tighten monetary policy at a faster pace than expected. The 10-year yield hit 3.11 percent last week — its highest level since 2011 — while the two-year yield hovered around a near-decade high. “The actual impact of interest rate changes on equity prices depends on the reason interest rates are rising. If interest rates rise in anticipation of faster economic activity, this could lift growth expectations and also lower the equity risk premium,” noted Kostin.

The 10-year yield had risen about 71 basis points year to date through Friday, Kostin points out. Stocks, however, have weathered the sharp rise in yields thus far. Entering Monday’s session, the S&P 500 and Nasdaq composite were up 1.5 percent and 6.5 percent for the year, respectively, while the Dow Jones industrial average is flat. The small-caps Russell 2000, meanwhile, hit an all-time high last week and is up 5.9 percent in 2018.

Here’s the take-away from Goldman’s perspective: “The actual impact of interest rate changes on equity prices depends on the reason interest rates are rising. If interest rates rise in anticipation of faster economic activity, this could lift growth expectations and also lower the equity risk premium.”

Well, maybe. But this time around it’s unlikely that rising rates and a strengthening economy can co-exist for very long because of the unprecedented amount of variable-rate and/or short-term debt that’s out there. Governments around the world have borrowed at the short end of the yield curve to get historically low rates (Japan and Switzerland, with negative short term rates, actually lower their budget deficits when the borrow in this way), which means they have a ton of paper to refinance in any given year. As rates rise, the cost of the new debt that replaces the old goes up. The faster rates rise, the bigger the hole blown in government budgets.

The mortgage market is already feeling the effects of the past year’s rate increase, with 30-year fixed loans nearly a full percentage point higher. One explanation for the minimal supply of houses on the market is that exiting homeowners have lower-rate mortgages than they’ll be able to get if they sell and buy something else, so why sell?

So the net impact of rising rates will be more severe than ever before, which will change the “anticipation of faster economic activity” to “fear of a slowdown” in very short order. For stocks, this combination of interest rates that exceed their dividend yields and a rising likelihood of negative economic surprises will be potentially devastating.

One other thing that can be said with certainty about rising rates is that they represent a shift of resources away from borrowers and towards savers, something that in moral terms is long, long overdue. For most of the past two decades, savers have been impoverished by miniscule rates on bank CDs and government bonds, while borrowers have been living in refi paradise, seeing the cost of their debts drop steadily. That is not a good world for people trying to build capital the old fashioned way. So a world in which the ants benefit at the expense of the grasshoppers would be a nice change.