Now What?

This piece, by Doug Noland, originated here

September 18 – Reuters: “The world’s leading central banks are facing the risk that their massive efforts to revive economic growth could be dragged down again, with some officials arguing for bold new ideas to counter the threat of slow growth for years to come. A day after the U.S. Federal Reserve kept interest rates at zero, citing risks in the global economy, the Bank of England’s chief economist said central banks had to accept that interest rates might get stuck at rock bottom. In Japan, where interest rates have been at zero for more than 20 years, policymakers are already tossing around ideas for overhauling the Bank of Japan’s huge monetary stimulus program as they worry that it will be unsustainable in the future, according to sources familiar with its thinking. Separately a top European Central Bank official said the ECB’s bond-buying program might need to be rethought if low inflation becomes entrenched.”

Most just scoff at the notion that there has been a historic global Bubble, let alone that this Bubble has over recent months begun to burst. Talk of an EM and global crisis is viewed as wackoism. Except that the Federal Reserve clearly sees something pernicious in the world that requires shelving, after seven years, even the cutest little baby step move in the direction of policy normalization.

The Fed and global central banks responded to the 2008 crisis with unprecedented measures. When the reflationary effects of these policies began to wane, the unfolding 2012 global crisis spurred desperate concerted do “whatever it takes” monetary stimulus. This phase has now largely run its course, and there is at this point little clarity as to what global central bankers might try next.

Clearly, great pressure will remain to hold rates tight at zero. I fully expect policymakers at some point to see no alternative than to implement additional QE. But under what circumstances? Will it be orchestrated independently or through concerted action? What about timing? How much and how quickly? Might global central banks actually consider adopting negative rates? Well, there’s enough here to really have the markets fretting the uncertainty, especially with global central bankers not having thought things through.

There is today extraordinary confusion and misunderstanding throughout the markets. Policymakers are confounded. Years of zero rates, Trillions of new “money” and egregious market intervention/manipulation have left global markets more vulnerable than ever. Now What? I’m the first to admit that global Credit, market and economic analyses are these days extraordinarily complex – and remain so now on a daily basis. We must test our analytical framework and thesis constantly.

I am confident in my analytical framework and believe it provides a valuable prism for understanding today’s complex world. The current global government finance Bubble is indeed the grand finale of serial Bubbles spanning about 30 years. Importantly, each Boom and Bust Bubble Cycle – going back to the mid-eighties (“decade of greed”) – spurred reflationary policy measures that worked to spur a bigger Bubble. Inevitably, each bursting Bubble would ensure only more aggressive inflationary policy measures.

It is fundamental to Credit Bubble Theory (heavily influenced by “Austrian” analysis) that the scope of each new Bubble must be bigger than the last. Credit growth must be greater, speculation must be greater and asset inflation must be greater. This Financial Sphere inflation is essential to sufficiently reflate the Real Economy Sphere – i.e. incomes, spending, corporate earnings/cash flows, investment, etc. Reflation is necessary to validate an ever-expanding debt and financial structure, including elevated asset prices. Ongoing rapid Credit growth is fundamental to this entire process, much to the eventual detriment of financial and economic stability.

There are a few key points that drive current analysis (completely disregarded by conventional analysts). First, the government finance Bubble saw historic Credit growth unfold in China and EM – Credit expansion sufficient to reflate a new Bubble after the bursting of the mortgage finance Bubble. Central to my thesis: when the current Bubble bursts – especially with regard to China – it will be near impossible to spur sufficient global Credit growth to inflate a bigger ensuing Bubble. Second, with the global government finance Bubble emanating from the very foundation of contemporary “money” and Credit, it will be impossible for governments and central banks to extricate themselves from monetary stimulus (any tightening would risk bursting Bubbles). Third, extreme measures – monetary inflation coupled with market manipulation – spurred enormous “Terminal Phase” growth in the global pool of speculative finance. It’s been a case of too much “money” ruining the game.

“Moneyness of Risk Assets” has played prominently throughout the government finance Bubble period. Unlimited Chinese stimulus seemed to ensure robust commodities markets and EM economies generally. Limitless sovereign debt and central bank Credit appeared to guarantee ongoing liquid and continuous global financial markets – “developed” and “developing.” And with governments backstopping global growth and central bankers backstopping liquid markets, the perception took hold that global stocks and bonds offered enticing returns with minimal risk. Global savers shifted Trillions into perceived “money-like” (liquid stores of nominal value) ETFs and stock and bond funds. Government policy measures furthermore incentivized leveraged speculation.

And why not leverage with global fiscal and monetary policies promoting such a predictable backdrop? Indeed, speculative finance has over recent years played an unappreciated but integral role in global reflation. This process has created acute fragility to market risk aversion and a reversal of “hot money” flows.

Central to the bursting global Bubble thesis is that Chinese and EM Bubbles have succumbed – with policymakers rather abruptly having lost control of reflationary processes. Measures that elicited predictable responses when Bubbles were inflating might now spur altogether different behavior. A year ago, Chinese stimulus incited speculation – and associated inflation – in domestic financial markets, while bolstering China’s economy and EM more generally. Today, in a faltering Bubble backdrop, aggressive Chinese measures weigh on general confidence and stoke concerns of destabilizing capital flight and currency market instability.

In the past, a dovish Fed would predictably bolster “risk-on” throughout U.S. and global markets. Times have changed. As we saw this week, an Ultra-Dovish Fed actually exacerbates market uncertainty. The global leveraged speculating community is these days Crowded in long dollar trades. Federal Reserve dovishness – and resulting pressure on the dollar – thus risks reinforcing “risk off” de-risking/de-leveraging. In particular, the yen popped on the Fed announcement, immediately adding pressure on already vulnerable yen “carry trades” (short/borrow in yen to finance higher-yielding trades in other currencies). While EM currencies generally enjoyed small bounces (likely short covering) this week, for the most part EM equities traded poorly post-Fed. European equities were hit hard, while the region’s bonds benefited from the prospect of more aggressive ECB QE.

The bullish contingent has clung to the view that EM weakness has been a function of an imminent Fed tightening cycle. In the market’s mixed reaction to Thursday’s announcement, I instead see support for my view that the bursting EM Bubble essentially has little to do with current Federal Reserve policy.

The bursting China/EM Bubble is the global system’s weak link. Surely the activist Fed would prefer to do something. They must believe that hiking rates – even if only 25 bps – would support the dollar at the risk of further straining commodities and EM currencies. Moreover, the FOMC likely sees any “tightening” measures as exacerbating general market nervousness and risk aversion. Moreover, the Fed must believe that dovish surprises will be effective in countering a tightening of financial conditions in the markets, as they were in the past.

Major Bubbles are so powerful. It was amazing how long the markets were willing to disregard shortcomings and risks in China and EM (financial, economic and political). Similarly, it’s been crazy what the markets have been so willing to embrace in terms of Federal Reserve and global central bank doctrine and policy measures. With their Bubble having recently burst, Chinese inflationary measures are now significantly hamstrung by an abrupt deterioration in confidence in policymaker judgment and the course of policymaking. I believe Thursday’s Fed announcement marks an important inflection point with respect to market confidence in the Fed and central banking.

Japan’s Nikkei dropped 2% Friday, and Germany’s DAX sank 3.1%. Both have been global leveraged speculating community darlings. Crude was hammered 4.2% Friday, with commodities indices down about 2%. Notably, the Brazilian real was trading at 3.83 (to the dollar) prior to the Fed announcement, before sinking 3% to a multi-year low by Friday’s close. Reminiscent of recent market troubles, financial stocks led U.S. equities lower on Friday. Financials badly underperformed for the week, with Banks down 2.7% and the Securities Broker/Dealers sinking 2.6%.

The market deck has been reshuffled for next week. A lot of market hedging took place during the past month of market instability. And a decent amount of this protection expired (worthless) with Friday’s quarterly “triple witch” options expiration. This means that if the market resumes its downward trajectory next week many players will be scampering again to buy market “insurance.” This creates market vulnerability to another “flash crash” panic “risk off” episode.

I am not predicting the market comes unglued next week. But I am saying that an unsound marketplace is again vulnerable to selling begetting selling – and another liquidity-disappearing act. Bullish sentiment rebounded quickly following the August market scare. The bear market will be well on its way if August lows are broken. I’m sticking with the view that uncertainties are so great – especially in the currencies – the leveraged players need to pare back risk. And the harsh reality is that central bank policymaking is the root cause of today’s extraordinary uncertainties and market instability.

In closing, I’m compelled to counter the conventional view that the Fed should stick longer at zero because there is essentially no cost in waiting. I believe there are huge costs associated with thwarting the market adjustment process. Measures that contravene more gradual risk market declines only raise the likelihood of eventual market dislocation and panic. This was one of many lessons that should have been heeded from the 2007/2008 experience.