Doug Noland: Unfolding Instability Thesis

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.


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.


Original Post 26 May 2018


TSP & Vanguard Smart Investor

Categories: Doug Noland, Perspectives