Submitted by Doug Noland – Credit Bubble Bulletin
A few Friday Bloomberg headlines: “Asian Stocks Jump by Most in Four Months on Stimulus Speculation;” “Japanese Stocks Surge by Most in Four Months as Bears Retreat;” “Hong Kong Dollar Jumps Most in 12 Years as Global Stocks Rally.” It was quite a week.
Back in early December I posited that Mario Draghi had evolved into the world’s most powerful central banker. I also stated my view that his inability to orchestrate a larger ECB QE program was likely an inflection point in the markets’ confidence in Draghi and central banking more generally. Mario’s not going down without a fight.
Global markets were too close to dislocating this week. Wednesday saw the S&P500 trade decisively below August lows. Japan’s Nikkei 225 Index sank to test November 2014 lows. Emerging stocks fell to six-year lows, with European equities at 13-month lows. Wednesday also saw WTI crude trade below $27 (sinking almost 7%), boosting y-t-d losses to 25%. Credit spreads were blowing out, and currency markets were increasingly disorderly. Early Thursday trading saw the Russian ruble down 5.3% (at a record low vs. dollar), with Brazil’s real also under intense pressure. The Hong Kong dollar peg was looking vulnerable. The VIX traded to the highest level since the August “flash crash,” while the Japanese yen traded to one-year highs (vs. $). De-risking/de-leveraging dynamics were quickly overwhelming global markets.
The Italian banking sector sank 7% Wednesday, pushing y-t-d losses above 20% (down 32% from 2015 highs). Fears of mounting bad loans and undercapitalization have been weighing on Italian and European bank shares and bonds. This week also saw a notable widening of sovereign spreads to bunds. Despite a post-Draghi narrowing of risk premiums, Italian spreads to bunds widened another seven bps this week, with Portuguese spreads blowing out 35 bps. A fragile European financial sector was rapidly succumbing to a deepening global financial crisis.
January 21 – Financial Times (Claire Jones and Elaine Moore): “Mario Draghi signalled that the European Central Bank is prepared to launch a fresh round of monetary stimulus as soon as March, bolstering a recovery on US and European equities in the wake of heavy losses this year. The ECB president said it would ‘review and possibly reconsider’ its monetary policy stance at its next meeting in six weeks… ‘We are not surrendering in front of these global factors,’ he said, referring to the China slowdown and the falling oil price that have destabilised global markets in recent weeks. The ECB has ‘the power, the willingness, the determination to act, and the fact that there are no limits to our action’ to bring inflation up to its target of just below 2%, he added. Policymakers, he said, would ‘absolutely reject’ attempts to derail their efforts to raise inflation ‘without undue delay’.”
January 22 – Bloomberg (Roxana Zega and Alan Soughley): “European stocks posted their biggest two-day gain since October 2011 on increased investor confidence that central banks will act to support markets. The Stoxx Europe 600 Index rose 3% to 338.36 at the close of trading, taking its two-day climb to 5%.”
Italian bank stocks rallied 7% Thursday on Draghi. Germany’s DAX index surged 5.6% off Wednesday’s lows. Stocks in Spain and Italy rallied 7% and 8%. Japan’s Nikkei surged 5.88% on Friday. Overall, from Wednesday’s lows the S&P500 recovered 5.5%. Crude oil enjoyed its “biggest rally in seven years” (up almost 17% from Wednesday lows).
Bloomberg adjusted its original Friday morning headline, “Global Stocks Charmed by Draghi Effect as Oil Rallies With Ruble,” to “Global Stocks Charmed by Central Banks as Oil Jumps, Bonds Fall.” Draghi did have some help. The People’s Bank of China (PBOC) injected $61 billion of liquidity into the system, the “most in three years.” China’s Vice President assured the markets that Beijing will “look after” Chinese stock investors. There was also talk of added stimulus from the Bank of Japan (BOJ) and a much more dovish Fed. The markets interpreted a feistily dovish Draghi as evidence that global central bankers had assumed crisis-management mode.
The markets will now have six-weeks to ponder whether Draghi can deliver. Even assuming that he successful drags ECB hawks along, it’s not easy to envisage how an additional $10 billion or so of QE will have much impact on (bursting) global Bubble Dynamics. An emphatic Draghi was, however, certainly capable of reversing global risk markets that were increasingly positioned/hedged for bearish outcomes. Over the years we’ve witnessed powerful short squeezes take on lives of their own, repeatedly giving the global Bubble an extended lease on life. And while bear market rallies tend to be the most spectacular, at this point I expect nothing beyond fleeting effects on the unfolding global Bubble unwind. Draghi is a seasoned pro at punishing speculators betting against Europe.
The media fixates on “corrections,” “bottoms” and “bear markets.” Of late, there’s been some comparison of the current backdrop to previous periods, most notably 2008/09 and 2000. I have no desire to try to leapfrog other bearish commentary. My objective is always to present an analytical framework that assists in understanding the extraordinary world in which we live and operate.
Going back to 2009, I’ve referred to the “global government finance Bubble” as the “Granddaddy of All Bubbles.” I am these days more fearful than ever that this period has indeed been the terminal phase of decades of serial Bubbles. Bubble excess made it to the heart of contemporary “money” and Credit – central bank Credit and government debt. This period also saw a historic Bubble engulf the emerging markets, including China. It encompassed stocks, bonds, derivatives and financial assets generally – virtually everywhere. Central bankers “printed” Trillions out of thin air.
Today’s predicament is becoming increasingly apparent: as the current global Bubble deflates and risk aversion takes hold, there is both a lack of sources of reflationary Credit and insufficient economic growth potential necessary to inflate an even bigger reflationary global Bubble. With confidence in central banking waning and the monstrous Chinese Bubble faltering, there is confirmation in the thesis that a most prolonged period of inflationary financial Bubbles is drawing to a close.
The collapse of the Soviet Union coupled with the Greenspan Fed’s push into activist central banking ushered in what was almost universally accepted as an epic victory for free-market capitalism. Too much of this was a quite powerful illusion. U.S. finance was becoming increasingly state-directed. The Fed manipulated interest-rates and the shape of the yield curve. The Washington-based GSEs moved to completely dominate mortgage Credit. The massive U.S. “too big to fail” financial conglomerates came to dictate securities and derivatives-based finance – and market-based finance monopolized the real economy. And each faltering Bubble ensured more aggressive central bank “activism” – lower rates, greater market intervention and increasingly outlandish talk of “helicopter money” and the government printing press.
With the bursting of the mortgage finance Bubble, the Fed and global central banks resorted to desperate measures – reckless “money” printing, manipulation and market liquidity backstops. Along the way, virtually the entire world adopted U.S.-style market-based finance and policymaking. The process culminated with communist China adopting U.S.-style finance. So long as inflating financial markets were supportive of central planner objectives, everyone could pretend it was a move toward free markets.
What began with Greenspan’s early-nineties covert bank recapitalization evolved into Bernanke’s foolish policy to openly inflate risk markets with new central bank Credit. Amazingly, U.S. inflationism took the world by storm.
The issue today goes much beyond a stock market correction, a bear market or even global financial crisis. Contemporary central banking has failed. Theories have failed. Doctrine has failed. The inability to spur self-sustaining economic recovery has been a major issue. Yet, from my perspective, the critical failure has been the incapacity to generate general price inflation. The delusion has been that central bankers would always enjoy the capacity to inflate away excessive debt levels. Bubbles needn’t be feared, not with central banks “mopping” up with reflationary monetary stimulus. And for quite a while it seemed that “enlightened” contemporary inflationist doctrine had it all figured out.
Central bankers and market-based finance are a dangerous mix. Over the years, I have referred to market-based finance as the most powerful monetary policy transmission mechanism in the history of central banking. Greenspan could inflate the markets – and the entire system – with inklings of a 25 bps rate cut. Later it took Dr. Bernanke Trillions – the dawn of “whatever it takes,” and markets rejoiced.
Central banks around the world abused their newfound power and the power of financial markets. And for seven years egregious monetary inflation has been used specifically to inflate global securities markets. And “shock and awe,” “whatever it takes,” and “push back against a tightening of financial conditions” all worked to ensure the markets that central bankers would no longer tolerate crises, recessions or even a bear market.
For seven long years, risk misperceptions and market price distortions turned progressively more severe. Inflating securities markets around the globe became, as they do, self-reinforcing. “Money” flooded into the markets – especially through ETFs and derivatives. Trillions flowed into perceived safe equities index and corporate debt instruments. With central bankers providing a competitive advantage for leveraging and professional speculation, the hedge fund industry swelled to $3.0 TN (matching the $3 TN ETF complex). Wealth effects and the loosest financial conditions imaginable boosted spending, corporate profits, incomes, investment, tax receipts and GDP – not to mention M&A, stock repurchases and financial engineering.
But this historic wealth illusion has been built on a foundation of false premises – that central bank monetization can inflate price levels and spur system inflation necessary to grow out of debt problems; that securities markets should trade at higher multiples based upon contemporary central banker capacities to spur self-reinforcing economic recovery and liquid securities markets; that 2008 was “the hundred year flood.” In reality, central bankers inflated history’s greatest divergence between global securities prices and economic prospects.
Global markets have commenced what will be an extremely arduous adjustment process. Markets must now confront the harsh reality that central bankers don’t have things under control. Risk premiums must rise significantly – which means the destabilizing self-reinforcing dynamic of lower securities prices, faltering economic growth, uncertainty, fear and even higher risk premiums. This means major issues for global derivatives markets that have inflated to hundreds of Trillion on misperceptions and specious assumptions. I’ll assume Draghi, Kuroda, Yellen, the PBOC and others resort to more QE – and perhaps they prolong the adjustment period while holding severe global crisis at bay. But the global Bubble has burst. And if QE has been largely ineffective in the past, we’ll see how well it works as confidence in central banking withers. Perhaps this helps explain why global financial stocks now trade like death.