Doug Noland: A Dubious Monetary Backdrop

Now that was one eventful week. President Trump wasted not a minute in making good on a series of campaign promises. A bevy of executive orders moved to rein in Obamacare, withdraw from Trans-Pacific Partnership (TPP) trade negotiations, tighten immigration, cut regulation and advance the Keystone Pipeline. No earth-shattering surprises there. Perhaps more startling, Team Trump had yet to even unpack before broaching radical notions such as abandoning America’s strong dollar policy, imposing a 20% border tax on imports from Mexico and opening direct confrontation with the media. Friday evening from the WSJ: “Trump’s First Week: Governing Without a Script.”

At least for this week, I’ll leave it to others to pontificate on the economic merits of Trump policymaking. Dow 20,000 is testament to the market’s ongoing fixation with tax reduction and reform, de-regulation and imminent fiscal stimulus. There were enough disquieting developments this week to dent confidence, though break-out bullish exuberance proved resilient. Unwavering faith in the course of central banking surely underpins the markets, confidence that I expect to be challenged in 2017.

My focus – one that the world now largely neglects – is on unsound global finance. It’s such an extraordinary backdrop – in all things monetary, in politics, geopolitics and the markets. Yet it is anything but a new experience for speculative markets to disregard latent financial fragilities. And we’ve witnessed in past episodes the capricious nature of market psychology. There’s something to glean from each one.

I think back to the summer of 1998. Markets were surging to record highs, led by monster advances in bank and financial stocks. The mantra was “the West will never allow Russia to collapse” – certainly not after the devastating Asian Tiger debacle. The simultaneous autumn implosions of Russia and LTCM not only punctured the financial Bubble, they almost brought down the global financial system.

Bolstered by “The Committee to Save the World” and all the Fed’s Y2K histrionics, powerful Bubble reflation saw Nasdaq almost double in 1999. Fear somehow just vanished as greed took full control. The U.S. was the indisputable leader of the free-world; there was an unassailable New Paradigm of technology-induced prosperity; America was the vanguard of technological revolution; and the dollar was unconditional king. With the clairvoyant Maestro leading U.S. and global central bankers, the New Millennium was destined to be the golden age of prosperity. Naysayers were tarred and feathered, yet that didn’t change the harsh reality that finance was fundamentally unsound.

These days, markets have grown convinced that Beijing will avert Chinese financial and economic crisis. The Bank of Japan will secure bond prices in Tokyo – no matter how much government debt is issued. The ECB will hold together Italy, Portugal, Spain and euro integration more generally. The Fed will not tolerate any meaningful tightening of financial conditions, ensuring the sustainability of bull markets in U.S. financial assets. The U.S. and king dollar provide a stable foundation for global finance that, along with ongoing Chinese growth, will hold EM debt crisis at bay. And, more generally, the Fed and international central bankers will continue backstopping global markets, guaranteeing ample liquidity and buoyant securities prices. Bear markets – let alone crisis – are simply intolerable.

Examining the backdrop, I think mostly deeply of 2007. For the most part, things looked pretty good at the time – at least superficially. The U.S. and global economy were generally viewed as robust, certainly strong enough to withstand some issues at the fringe of mortgage finance (subprime). Very few at the time recognized the profound financial and economic fragilities that had developed over the mortgage finance Bubble period. In general, policymakers and market participants were oblivious to how distortions in the pricing and issuance of mortgage finance had become such a critical systemic issue. Virtually everyone missed the key analysis: Perceived solid economic fundamentals were no match for deeply unstable financial and market underpinnings. It was a major Bubble, and it would burst.

I believe fragilities today are much more systemic on a global basis than back in 2007. Where’s the Bubble? Virtually everywhere. Indeed, the world would be altogether different if not for the past year’s $2.0 TN or so of global central bank liquidity injections – and expectations for only somewhat less this year. It’s noteworthy that few market strategist even mention QE these days – as if it no longer matters. With the Fed having suspended QE in 2014, there’s a general perception in the U.S. that markets will transition easily away from QE. Yet global liquidity is “fungible.” How much U.S. bound liquidity has arrived – directly or indirectly – via ECB, BOJ and BOE QE operations? Surely flows have been enormous – hundreds of billions or, likely, more.

Fixated so on Trump, markets have lost focus on the crucial issue of global QE prospects. Expect this to be a short-term phenomenon. The ECB and BOJ are in the middle of colossal policy mistakes. Both grabbed the QE hot potato from Federal Reserve – and now they’re stuck. Both have been buying massive quantities of government debt at highly inflated Bubble prices. Both doubled-down in 2016. Both should be addressing exit strategies but are afraid.

Mario Draghi has been using the electronic printing press as a desperate measure to hold the euro together. The BOJ succumbed to a fool’s errand of pegging government bond yields near zero. European yields have begun rising briskly on the prospect of reduced central bank purchases. The Bank of Japan faces a choice of either massive ongoing purchases necessary to hold yields down – with negative ramifications for the yen – or admitting to a policy blunder and dealing with a spike in yields.

I view the global monetary backdrop as highly problematic. Let’s focus first on Europe. This week saw Italian yields jump 22 bps to 2.23%, the high since July 2015. Portuguese yields surged 32 bps to 4.14%, trading above 4.0% for the first time since March 2014. Greek yields rose 15 bps to 7.11%. Even French yields rose 13 bps this week to 1.03%, the high since July 2015. It’s worth noting that the spread between French and German 10-year yields widened nine bps this week (to 57bps) to the widest level since April 2014.

January 25 – Wall Street Journal (Tom Fairless): “A top European Central Bank official signaled… that the ECB should soon start to wind down its €2.3 trillion bond-purchase program, a much anticipated move that is expected to trigger volatility in financial markets. ‘I am…optimistic that we can soon turn to the question of an exit’ from easy-money policies, said Sabine Lautenschläger, who sits on the ECB’s six-member executive board… The ECB ‘must get ready for better times,’ Ms. Lautenschläger said.”

January 26 – Financial Times (Claire Jones): “Mario Draghi will be disappointed. It has taken just a week after the European Central Bank’s latest policy vote for the governing council’s two most hawkish members to cast doubt on his plans to buy €780bn-worth of bonds under the landmark quantitative easing programme this year. Jens Weidmann, the Bundesbank president, has echoed the remarks his fellow German Sabine Lautenschläger, a member of the ECB’s executive board, made Tuesday and indicated the debate on trimming QE should begin soon. ‘The economic outlook at the beginning of the year is quite positive and the inflation rate is gradually approaching the ECB’s definition of price stability. If this price development is sustainable, the requirements for the withdrawal from the loose monetary policy are met,’ Mr Weidmann said…”

German central bankers appear increasingly anxious – and less willing to maintain a low profile. Germany’s CPI jumped to a (non-deflationary) 1.7% y-o-y rise in December, the strongest pace since July 2013. December Import Prices were up 3.5% y-o-y, the strongest since early 2012. There are important German elections this fall. The ECB is scheduled to reduce monthly purchases from 80 billion euros to 60 billion in April. Expect the more hawkish contingent at the ECB to begin pushing for a 2017 end to QE operations.

While the issue garners little attention these days, it appears increasingly likely that euro zone central banks will sustain large losses on their bond portfolios. Perhaps it doesn’t matter. Or perhaps it will embolden the “hawks” – and even, at some point, unnerve the markets. It’s important uncharted territory for policymakers and the markets. After early-2016 policy moves, markets turned fully persuaded that central banks were willing and able to unleash unlimited resources to support market liquidity and securities prices. This assumption is now deeply embedded in securities prices – across asset classes and around the globe.

Much has changed in a year. Brexit, Trump, crude and commodities prices, equities markets, bond yields and inflationary dynamics more generally – to name only a few. A strong case can be made that desperate central bank measures pushed the global bond Bubble to speculative “blow off” extremes – just as inflationary forces garnered some momentum. While yields have for the most part reversed sharply, a possible major market (burst Bubble) adjustment has been held at bay by ongoing massive QE.

On the political front, President Trump’s America First – anti-globalization, anti-establishment – agenda also complicates what had become a rather predictable central banking environment (“whatever it takes” in the name of robust global securities markets). Sure, Federal Reserve officials can continue to lecture as if their purpose in life is wholly dictated by the “dual mandate.” Yet Yellen – following in the footsteps of predecessors Bernanke and Greenspan – is an activist promoter of globalization and global securities markets. It’s interesting to hear even some of the most dovish Obama Fed appointees take on an almost hawkish tone when it comes to potential Trump fiscal stimulus. Might the Fed choose to adopt a less activist stance down the road when markets respond negatively to aspects of the Trump agenda?

Throughout the financial crisis until now, global central bankers have been a united and unifying force. Can this dynamic be maintained in a backdrop of rising animosity within societies/political ideologies and between governments and nations? In the event of a U.S. initiated trade war, should we expect, for example, such close cooperation between the Fed, the Bank of Mexico and the People’s Bank of China?

And what are the ramifications for the Trump Administration ditching the so-called “strong dollar policy”? Might we see Tweets attacking ECB and BOJ QE on grounds they’re part of a currency devaluation strategy? Trump has been critical of the Fed. He’s surely no proponent of the euro experiment and the ECB’s approach to “whatever it takes” monetary management. There’s great global uncertainty with regards to future trade relations, inflation, fiscal deficits and monetary policy. Past market performance may not be all that relevant to a quite divergent future.

January 24 – New York Times (Alan Rappeport): “After seven years of fitful declines, the federal budget deficit is projected to swell again, adding nearly $10 trillion to the federal debt over the next 10 years, according to projections from the nonpartisan Congressional Budget Office… Statutory caps imposed in 2011 on domestic and military spending have helped temper the deficit. But those controls are likely to be swamped by health care and Social Security spending that will rise with an aging population.”

Going back to the nineties, aggressive GSE market intervention played a profound roll in backstopping and reflating markets after repeated de-risking/de-leveraging episodes. The (late-2004) revelation of accounting scandals constrained their ability to aggressively provide marketplace liquidity. Yet the loss of this key backstop mechanism didn’t slow markets that had by then developed powerful inflationary momentum. The view was that Washington – the Treasury, Fed and GSEs – would never tolerate a housing bust. And this view was integral to an historic financial and economic Bubble – and deeply embedded in securities markets (equities and fixed-income, at home and abroad).

The scope of today’s global Bubble goes so far beyond 2007. The prevailing view holds that global central banks will indefinitely do “whatever it takes” to ensure abundant marketplace liquidity, while backstopping global markets in the event of tumult. And it is precisely this perception that has sustained a prolonged Credit and asset inflation and resulting epic financial Bubble.

January 27 – Wall Street Journal (Kane Wu and Julie Steinberg): “The pace of big Chinese takeovers abroad is slowing as buyers contend with rules tightening the flow of money out of the country and increased government scrutiny at home and overseas. Bankers say many of the record-breaking $225 billion in overseas acquisitions Chinese companies announced last year are stalled by financial or regulatory hurdles—including the country’s biggest-ever deal, China National Chemical Corp.’s $43 billion bid for Syngenta AG, a Swiss seed and pesticide maker… More Chinese acquirers are backing out of deals.”

January 26 – Bloomberg: “China’s escalating crackdown on capital outflows is sending shudders through property markets around the world. In London, Chinese citizens who clamored to purchase flats at the city’s tallest apartment tower three months ago are now struggling to transfer their down payments. In Silicon Valley, Keller Williams Realty says inquiries from China have slumped since the start of the year. And in Sydney, developers are facing “big problems” as Chinese buyers pull back, according to consultancy firm Basis Point. ‘Everything changed’ as it became more difficult to send money offshore, said Coco Tan, a broker at Keller Williams in Cupertino, California.”

While the markets still have a number of weeks prior to any global QE reduction, the effects of less liquidity emanating from China are already being felt. There were this week indications of further tightening of capital controls. Officials also appeared to ratchet up efforts to restrain Credit growth (See “China Bubble Watch” below).

January 26 – Bloomberg: “China’s central bank has ordered the nation’s lenders to strictly control new loans in the first quarter of the year, people familiar with the matter said, in another move to curb excess leverage in the financial system. The new guidance from the People’s Bank of China puts a particular emphasis on mortgage lending, …as authorities grapple to contain runaway property prices. And while the PBOC regularly seeks to guide banks’ credit decisions, this time it may also make errant lenders pay more for deposit insurance, one of the people said… ‘This is a continuation of the tightening trend we’ve seen since the second half of last year and extends from shadow banking to on-balance sheet loans,’ said Wei Hou, a Hong Kong-based analyst at Sanford C. Bernstein…”

January 27 – Wall Street Journal (James T. Areddy): “A Chinese phone maker’s failure to repay around $166 million in bonds has rippled through the world’s largest internet investment marketplace, hitting investors who hadn’t even bought the securities. The default, by phone maker Cosun Group, is one of the most high-profile failures to hit China’s sprawling network of Internet-based financial firms. It is an embarrassment to Alibaba Group Holding Ltd. because its affiliate Ant Financial Services Group owns the investment marketplace where the bonds were sold, and illustrates a rising risk in China, where hundreds of millions of people seeking higher returns on their savings have used their mobile phones to buy risky, unregulated investments.”

In a world of unsound finance, China remains a major weak link. And while the United States’ relationship with our southern neighbor received most of the attention during the first week of the Trump Administration, I’ll be surprised if China escapes Trump Tweets for long. Prospects for growth in GDP and U.S. corporate profits seem enticing to most these days. I would counter that global financial and economic stability cannot be taken for granted if the U.S. and China come to loggerheads. Latent fragilities will spring to life.

Even if calm prevails, markets have grown way too complacent regarding the global monetary backdrop. So many unknowns. So many things that could go wrong. Whenever it unfolds, the next de-risking/de-leveraging episode should be quite captivating.

Original Post 28 January 2017

Categories: Perspectives