Doug Noland: The Great Fallacy

The pressing issue for global markets goes far beyond widening interest-rate differentials. Markets anticipate a future with the Draghi ECB eager to expand QE and, across the pond, the Powell Fed reluctant to redeploy QE – in a world increasingly vulnerable to a globally systemic market liquidity event. Markets see a stimulus-driven overheated (“Core”) U.S. economy distancing itself from faltering (“Periphery”) Bubbles in EM and Europe. Recalling how cracks in subprime worked to extend “Terminal Phase Excess” in prime U.S. mortgages right into the 2008 crisis, serious issues today at the global “periphery” ensure financial conditions remain dangerously loose for the late-cycle U.S. boom.

[Michael Bond: I’ve bolded a key take-away from Doug’s excellent analysis in the paragraph above.

I also want to add the thought that central banks in the past have responded not to the economy but to the over-indebted global financial sphere which has and will come under stress long before the real economy and inflation respond. This is Fed Chairman Powell’s dilemma as the US economy expands into inflation pressures – something the last two Chairpersons did not have to worry about.

Globally interest rates remain below inflation and yet we are still seeing financial stress in emerging markets and Europe – this does not bode well for normalization.  The Fed today is merely attempting to take the financial system off  life support with their fingers crossed. Good luck.]


The Great Fallacy

A big week in the world of monetary management: The Federal Reserve raised rates 25 bps, the ECB announced plans to wind down its historic QE program, and the Bank of Japan clung to its “powerful monetary easing” inflationist scheme. A tense People’s Bank of China left rate policy unchanged, too weary to follow the Fed’s path.

The renminbi declined a notable 0.5% versus the dollar this week. More dramatic, the euro was hammered 1.9% on Draghi’s game plan. Also on Thursday’s dollar strength – and even more dramatic – the Argentine peso sank another 6.2% (down 34% y-t-d). The session saw the Brazilian real drop 2.2%, the Hungarian forint 2.6%, the Czech koruna 2.2%, the Polish zloty 2.0%, the Bulgarian lev 1.9%, the Romanian leu 1.9% and the Turkish lira 1.7%.

The FOMC, raising rates and adjusting “dot plots” higher, was viewed more on the hawkish side. The ECB, while announcing plans to conclude asset purchases by the end of the year, was compelled to add dovish guidance on rate policy (“…expects the key ECB interest rate to remain at present levels at least through the summer of 2019…”). Blindsided, the market dumped the euro. The Fed and ECB now operate on disparate playbooks, each focused on respective domestic issues. Anyone these days focused on faltering emerging market Bubbles, global contagion and the rising risk of market illiquidity?

June 13 – Financial Times (Sam Fleming): “Jay Powell put his personal stamp on the Federal Reserve on Wednesday, as the new chairman vowed to speak in plain English and hold more regular press conferences as he fosters ‘a public conversation’ about what the US central bank is up to. The Fed’s statement after the Federal Open Market Committee meeting, which detailed its decision to raise rates 0.25% and set a course for two more increases this year, also bore his imprint, as Mr Powell stripped away some of the economic verbiage that cluttered its communications in recent years. Mr Powell’s break from the approach of his predecessor… was more a stylistic one than a radical change of monetary policy strategy.”

It may be subtle, but Chairman Powell appears ready to break from both his predecessors and fellow global central bankers. So far, there’s been the envisioned continuity, along with a traditional element of caution when it comes to adjusting central bank doctrine. There are, however, indications that Powell is ready to distance his committee from the Fed’s recent radical monetary experiment.

Mr. Powell’s plain-speaking approach is refreshing. He is the antithesis of “Greenspeak.” The new Chairman is clear, concise and devoid of obfuscation. He’s no ideologue. There are no glaring idiosyncrasies, for a change. Powell appears the adept and confident leader, yet he demonstrates an admirable humility when it comes to pontificating about today’s exceedingly complex backdrop. The Chairman has also abandoned much of the academic narrative that too often ensures economic analysis and discussion turn hopelessly convoluted and divorced from reality.

June 14 – Bloomberg (Jeanna Smialek): “Federal Reserve Chairman Jerome Powell doesn’t claim to have all of the answers, but when it comes to where unemployment can settle in the long run, he and his colleagues are especially stumped. ‘No one really knows with certainty what the level of the natural rate of unemployment is,’ Powell told reporters… Later, pressed about whether the Fed’s long-run estimate, now at 4.5%, could come down, he indicated that it’s possible. ‘We can’t be too attached to these unobservable variables.’ It’s a crucial uncertainty, because the natural jobless rate is a linchpin of Fed policy.”

The Fed Chairman is also moving to a press conference following each FOMC meeting. I suspect there’s more to this move than a desire for greater transparency. The markets have been assuming that significant policy moves would only occur during meetings with scheduled press conferences. Powell would prefer the markets not make such presumptions. Every meeting is live. Data matter. There are financial stability risks when the Fed pre-commits on policy or becomes hamstrung by market expectations.

The past few Fed chairs were keen to use forward guidance as part of their strategies to manipulate market expectations, prices and economic outcomes. Powell, in what would be a major departure, appears to want the Fed out of the guidance and manipulation business. It’s an uncertain world, and financial markets must be reacquainted with the capitalistic principle of markets standing on their own. He appreciates the extraordinary uncertainty in the economic, market, policy, and geopolitical backdrops. Powell views the economy as strong and ongoing monetary policy normalization as appropriate. Of course, there are downside risks. But in contrast to Draghi, Powell shows little predilection to dangle the carrot of monetary stimulus and liquidity backstops in front of a craving marketplace.

With his background in finance, I’ll assume the Chairman appreciates the speculative nature of current market dynamics. He is well aware of the powerful role the Greenspan/Bernanke/Yellen puts have played within the financial markets. Cognizant of market distortions, Powell would rather the markets not revel in the certitude of a Fed ready and willing to sprint immediately to the markets’ defense. On the surface, adjustments in the Powell Fed’s rate and communications policies appear less than far-reaching. But on the critical issue of the Federal Reserve’s approach to market-pandering policy guidance and market-bolstering liquidity backstops, I believe Powell is breaking with the progressively radical policy course that unfolded under Drs. Greenspan, Bernanke and Yellen.

Over in Frankfurt, Mario Draghi is having a devil of a time shedding “whatever it takes.” He stated the ECB’s intention to end QE at the end of the year. This is, however, “subject to incoming data confirming the Governing Council’s medium-term inflation outlook.” Markets hear Draghi discussing an exit, while seeing ECB forward guidance as virtually ensuring ongoing liquidity operations. Viewing unfolding developments in EM, Italy, the European periphery and vulnerable global markets more generally, markets see fragilities that create a high likelihood of future “whatever it takes” QE measures.

The pressing issue for global markets goes far beyond widening interest-rate differentials. Markets anticipate a future with the Draghi ECB eager to expand QE and, across the pond, the Powell Fed reluctant to redeploy QE – in a world increasingly vulnerable to a globally systemic market liquidity event. Markets see a stimulus-driven overheated (“Core”) U.S. economy distancing itself from faltering (“Periphery”) Bubbles in EM and Europe. Recalling how cracks in subprime worked to extend “Terminal Phase Excess” in prime U.S. mortgages right into the 2008 crisis, serious issues today at the global “periphery” ensure financial conditions remain dangerously loose for the late-cycle U.S. boom.

The risk of an upside dollar market dislocation is rising. That, at least, was how markets seemed to trade on Friday. The GSCI Commodities index fell 2.2%, with crude sinking $2.55, or 3.8%, in Friday trading. Silver (COMEX) was slammed 4.0%, gold 1.8% and Platinum 1.9%. Copper fell 2.5% and Nickel dropped 2.2%. Even in U.S. equities, it was sell industrials and materials and buy defensive. Treasury yields followed European yields lower, focused more on international developments than U.S. GDP or the trajectory of short-term interest rates. Despite the U.S. boom, there are rising concerns for the global economy. China ok?

June 13 – Bloomberg: “China’s broadest measure of new credit slumped in May to the lowest in almost two years, as a campaign to rein in the shadow banking sector gained traction. Aggregate financing stood at 760.8 billion yuan ($118.8bn) in May…, compared with an estimated 1.3 trillion yuan in a Bloomberg survey and 1.56 trillion yuan in April. The change was driven by a fall in off-balance sheet lending of 421.5 billion yuan, the most since data began in 2006… New yuan loans stood at 1.15 trillion yuan, versus a projected 1.2 trillion yuan, and broad M2 money supply increased 8.3%, compared with a forecast 8.5%”

China’s CNY 761 billion ($119bn) May increase in Total Social Financing not only badly missed estimates, it was the smallest monthly increase since July 2016. Y-t-d growth of CNY 17.990 TN ($1.235 TN) is running 16% below comparable 2017 – and was even below comparable 2016 Credit growth.

Beijing’s crackdown on shadow banking has had a dramatic impact. Major shadow bank components (i.e. trust loans, entrusted loans and undiscounted bankers’ acceptances) all contracted for the month. Corporate debt financings also declined during May (about $7bn).

At $180 billion, New Bank Loans were slightly below estimates and just below the May 2017 level. Importantly, lending (mostly mortgages) to the Household sector continues to grow at a rapid clip. May Household lending of CNY 614.3 billion ($96bn) expanded at 17.2% annual rate, with y-t-d growth at a 17.3% pace. This helps to explain an increasingly unbalanced Chinese economy.

June 14 – Reuters (Yawen Chen and Ryan Woo): “China’s home prices in May logged their fastest growth in nearly a year, suggesting buyers are targeting smaller cities even as the government steps up measures to clamp down on speculation. Average new home prices in China’s 70 major cities rose 0.7% in May from the previous month – the best pace since June 2017 – compared with a 0.5% increase in April…”

With real estate-directed lending booming, the resilience in the apartment price Bubble is easily explained. Related wealth effects are behind much stronger-than-expected May Imports (up 15.6% vs. expectations of 8.6%) – and China’s rapidly shrinking Trade Surplus. I would argue that China’s runaway mortgage finance and apartment Bubbles at this late stage of the cycle significantly increase the risk of systemic crisis.

In important sectors of the Chinese economy, there are indications that tighter Credit conditions are having an impact. Industrial Production (up 6.8%) and Fixed Investment (up 6.1%) both slowed and missed forecasts in May.

From Thursday’s NYT (Keith Bradsher): “Gary Liu, the president of the China Financial Reform Institute, a Shanghai-based research group, said on the sidelines of the Lujiazui Forum that China’s private-sector companies of all sizes, even large ones, had long faced challenges in obtaining loans. But the credit squeeze on them this spring has been particularly painful. ‘It’s very bad, and we see not just small and medium-sized enterprises defaulting but even big companies defaulting,’ he said.”

With the Trump administration Friday announcing $50 billion of tariffs on Chinese goods – supposedly with a list of an additional $100 billion ready to go – and China retaliating with its own tariffs on $34 billion, there are concerns for an escalating trade war. Returning to the potential for an upside dollar dislocation, China is today unusually financially and economically vulnerable.

A surging U.S. dollar would find Beijing in a difficult quandary. Maintaining China’s soft peg to the dollar would leave Chinese manufacturers in a disadvantageous position, right as Credit and liquidity conditions tighten and growth slows.

Chinese devaluation fears would reemerge, spurring capital flight and the unwind of leveraged holdings of higher-yielding Chinese Credit instruments. With China’s banks and corporations having over recent years borrowed aggressively in dollars, currency instability could quickly develop into Credit worries and market illiquidity. The Shanghai Composite dropped 1.5% this week, increasing y-t-d losses to 8.6%. The small cap CSI 500 index sank 3.3% (down 12.3% y-t-d), and China’s growth stock ChiNext index was slammed 4.1% (down 6.3%). It’s worth adding that Hong Kong’s Hang Seng Financials index fell 2.3% this week, trading near 2018 lows. Bank stocks traded poorly almost around the globe this week.

Here at home, the NFIB Small Business Optimism Index jumped three points in May to the highest reading since 1983. Preliminary June Michigan Consumer Confidence rose to a stronger-than-expected 99.3, with Current Conditions rising to the second-highest reading going back to 2000. Up a blistering 0.8% for the month, May Retail Sales blew away estimates. The Empire Manufacturing Index jumped to an eight-month high. May CPI was up 2.8% y-o-y, with PPI gaining 3.1% y-o-y. The Atlanta Fed’s growth forecasting model has real GDP expanding at a 4.8% clip.

The U.S. economy has grown too hot and markets too speculative. U.S. rates and market yields remain inappropriately low. The Powell Fed has set a course for rate normalization. Meanwhile, fissures open in the global Bubble. Global imbalances are coming home to roost. Resulting dollar strength has a very real possibility of becoming self-reinforcing and increasingly destabilizing. The Argentine peso sank 10.3% this week. The Turkish lira fell 5.4%, the South African rand 2.7%, the Hungarian forint 2.2%, the South Korean won 2.0% and the Mexican peso 1.6%. Yields rose again this week in Brazil, Argentina and Turkey. International markets seem to have a solid grasp of the immediately vulnerable countries. In short, the unfolding global crisis thesis remains on track.

Objectively, global markets indicating such fragility in the face of extraordinarily low rates and about $100 billion of ongoing monthly QE portends difficult challenges ahead. The notion that you can inflate your way out of Bubbles is The Great Fallacy of contemporary central bankers. They’ve inflated only bigger Bubbles.



Original Post 16 June 2018


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Categories: Doug Noland, Perspectives