Q1 2019: “What are Central Banks Afraid of?”
I’ve been doing this long enough that when I see my bear thesis coming to fruition - I’m conditioned to expect a policy response. Late in Q4, we viewed the dispersion of market probabilities chiefly split between two divergent scenarios: a major market downside dislocation and potential crash scenario - or a policy response and likely rally.
December was an especially challenging period analytically. “Risk off” de-risking/deleveraging dynamics were gaining momentum, yet the Fed held firm with cautious rate and balance sheet policy normalization at its December 19th meeting. The Fed was called “tone deaf” – and worse - and markets turned unstable.
Things took a turn for the worse on January 3rd as markets began convulsing toward dislocation. There was clear potential for speculator de-leveraging, derivative-related selling and a surge in ETF outflows, in particular, to spark synchronized illiquidity and disorderly trading across global markets. Markets had begun moving rapidly toward central bankers’ worst fear – a “seizing up” of markets that would have deflated global bubbles and revealed acute economic fragility.
Chairman Powell – appearing the following day in a panel discussion with Bernanke and Yellen – unexpectedly pulled out prepared remarks and instigated a dramatic policy U-turn. The Draghi ECB soon followed, as global central banks shifted to even more dovish postures. Later, in the face of surging global risk markets, the Fed surpassed dovish expectations at its March 20th meeting.
The timing of the January 4th inter-meeting Dovish U-turn – only a couple weeks after an FOMC meeting - was extraordinary. And here I will highlight an important distinction between our approach and all the competing bear products. When managing the amount and composition of our short exposure, we start with comprehensive top-down macro analysis of market risk vs. reward.
This is a lesson I learned the hard way in the early-nineties working for a short-biased hedge fund in San Francisco. Our focus was micro analysis of individual companies, with a top-down overlay. I watched as the macro environment completely overpowered our micro company research and analysis. Ever since, I’ve taken the approach that top-down analysis of policymaking, financial conditions and speculative market dynamics is paramount for effective risk management. Especially in today’s extraordinary backdrop, positioning decisions must start with macro analysis.
I doubt competing bear funds factored in the probability of a policy-induced market rally into portfolio management decisions. Most don’t adjust exposures or portfolio composition because of macro risks.
When the risk of a policy response and rally is high, I know better than to be short popularly shorted stocks. Short squeeze risk was highly elevated, and the Goldman Sachs Most Short index surged 18.8% during the quarter – certainly helping to explain dismal bear fund performance.
When policy and rally risks are high, we don’t want to be short “high beta” stocks or sectors. For the quarter, the Biotechs and Semiconductors both surged more than 21%.
The Fed moving abruptly to bolster the markets often prompts the unwind of bearish speculative positions in securities and derivatives, as well as inciting what can turn into a disorderly unwind of myriad market hedges, including options and sophisticated derivatives. This creates high-risk for unpredictable and disorderly sector rotations.
I’ll repeat a comment I made during January’s call: This is a highly abnormal market environment – one that has shifted away from traditional analysis and active management – to highly speculative “passive” trend-following strategies, algorithmic and high-frequency trading and sophisticated derivative structures.
I titled today’s call, “What are Central Banks Afraid of?” My thoughts return to “the maestro” Alan Greenspan. During the mortgage finance bubble period, he repeatedly asserted that there was no national bubble - because real estate markets are always a local phenomenon.
His analysis completely ignored the reality that the epicenter of the bubble was in finance – in New Age mortgage finance – the GSEs, Wall Street firms and big banks, the hedge funds and leveraged speculation, sophisticated derivative structures, booming MBS and ABS markets and such – all comprising a highly levered, speculative and distorted national financial bubble that was overfinancing housing speculation across the country.
It’s been a full decade since I began warning of the unfolding “global government finance bubble.” What continues to transpire is so beyond what I previously thought possible: Tightly interconnected global markets are now commanded by a massive pool of speculative finance – finance degraded by the perception that central bankers are there to fend off market instability, recessions and bear markets. The upshot has been dysfunctional global markets incapable of effectively assessing risk. The global Bubble backdrop is comprised of synchronized ultra-low interest rate policies; the synchronized expansion of central bank Credit; an unprecedented globalized expansion of sovereign debt; and the global proliferation of leveraged speculation and derivatives strategies.
It has become one complex, highly integrated and historic bubble. Markets have never been so synchronized, so speculative, so distorted – worldwide. I’ll repeat a couple of my old postulates: “Bubbles go to unimaginable extremes – then double.” And “Things turn crazy at the end of cycles.” As we’re witnessing, things turn really crazy during the late-stage of a historic cycle. And at this point, all the craziness somehow passes for business as usual.
Deficits don’t matter and never will: A federal deficit of $691 billion in only six months – running 15% above the year ago level. And speaker Pelosi recently said she would meet with President Trump to discuss infrastructure - at least a $1 trillion dollar plan but she would prefer $2 TN. - The newfound belief in the Modern Monetary Theory free lunch.
I’ll add an important point: It’s not that we don’t learn from history – but we learn from short-term history. I was reminded of how quickly things are forgotten last week when Bloomberg ran an article – “Evans Sees Lessons From 1998 Rate Cuts for Fed Policy This Year.” It said, “For the Chicago Fed president Charles Evans the situation recalls the Asian financial crisis of 1998. According to Evans, ‘The risk-management approach taken by the Fed is not unusual. It served us well in similar situations in the past.’”
I have trouble with historical revisionism. First of all, the Asian crisis was in 1997. The Fed aggressively reduced rates from 5.50% to 4.75% in the Autumn of 1998 in response to the simultaneous Russia and Long-Term Capital Management collapses. In Evans’ words, the Fed moved because of the “fallout on domestic financial conditions.” The reality was that these implosions posed risk to a vulnerable global financial system.
Quoting Evans: “How did this risk-management strategy turn out? In the end, the economy weathered the situation well. Productivity accelerated sharply, and by early 1999 growth was on a firm footing.”
Evans leaves out the near doubling of Nasdaq in 1999, along with what I refer to as “terminal phase” Bubble excess. The bottom line is the Fed aggressively loosened policy while the system was in the late-stage of a significant Bubble, and then failed to remove this accommodation until mid-November 1999.
And let’s not forget that the subsequent bursting of the so-called “tech bubble” led to what was -at the time - unprecedented monetary stimulus – including Dr. Bernanke’s speeches extolling the virtues of the government printing press and “helicopter money.” These measures were instrumental in fueling the mortgage finance bubble that burst in 2008. That collapse then led to a decade-long – and ongoing - global experiment in zero rates, open-ended money-printing and yield curve manipulation.
“What Are Central Banks Afraid of?” Foremost, I believe they are petrified that their great monetary experiment has been a failure. Instead of reflating out of over-indebtedness and economic stagnation, they have further inflated speculative bubbles while rampant debt growth runs unabated. Central banks are understandably frightened that they’re now trapped into perpetual loose policies necessary to placate highly speculative global markets while sustaining deeply structurally-impaired economic systems.
No matter how Evans and others spin success out of the Fed’s previous “risk management” efforts, system stability has been poorly served – repeatedly. For a long time now, the Fed and global central banks have taken radical measures that have worked to sustain Bubble Dynamics. We strongly argue that latent global financial and economic fragilities are today more acute than ever.
It has now been more than three decades of progressive central bank market intervention and manipulation. What began with Greenspan’s ‘87 post-crash assurance of system liquidity evolved into early-nineties yield curve manipulation to recapitalize bank capital after the collapse of the late-eighties bubble. There was then the ‘95 Mexican bailout, followed by the ’98 rate cuts and bailout of Long-Term Capital Management. The collapse of the tech bubble then provoked even more aggressive rate cuts and the promotion of mortgage credit excess in the name of system reflation. The mortgage finance bubble collapse incited unprecedented moves to zero rates and $1 TN of Federal Reserve QE, with synchronized aggressive policy stimulus around the world – including a $600 billion Chinese stimulus program. The Fed formulated an “exit strategy” in 2011 to normalize its bloated $2.2 TN balance sheet, only to then double assets over the next several years. 2012 European instability unleashed “whatever it takes” policies from the ECB and others.
When market instability briefly reemerged in 2013, chairman Bernanke stated the “Fed would push back against a tightening of financial conditions.” This was yet another giant leap in “activist” policymaking. Markets took Bernanke’s comment as the Fed ensuring an ongoing bull market.
Powered by unprecedented synchronized central bank liquidity injections and market assurances - speculative Bubbles went into overdrive. When Beijing belatedly moved to rein in excess in late-2015, weakness in China’s currency and markets risked bursting Chinese and global Bubbles. The Fed quickly postponed policy normalization, as the ECB and BOJ further expanded QE programs. Global central banks at the time were adding about $200 billion monthly of additional liquidity into global markets. After trading as low as 1,810 in February 2016, the S&P500 surged almost 60% over the next two years. The loosest non-crisis monetary policies imaginable were then combined with big U.S. tax cuts and fiscal stimulus.
When the Fed finally moved ahead with rate and balance sheet normalization, any negative liquidity impact from Fed balance sheet contraction was more than offset by the ongoing rapid expansion of other balance sheets – notably the ECB’s and BOJs. Financial conditions only loosened further.
The new Fed Chairman was not oblivious to prolonged monetary stimulus compromising financial stability. I believe Powell was hoping for a subtle change in direction, preferring the Fed to begin letting markets stand on their own.
The FOMC held its ground at the December 19th meeting, stating its intention to stay the course with cautious rate increases and balance sheet runoff - despite market instability. Markets turned highly agitated.
Only a couple weeks later, on January 4th, Powell made a fateful dovish “U-Turn.” Why the sudden change of heart? Well, the previous day saw a disorderly “flash crash” in key currency markets. Credit spreads widened significantly, and Credit default swap prices spiked. In short, de-risking/deleveraging dynamics were gaining momentum, with securities and derivatives markets in the process of dislocating. Bubbles were faltering. In the end, the Fed came once again to the markets’ defense, further cementing the view that central bankers have very little tolerance for market instability and deflating bubbles.
It’s been called the “everything rally.” The latest acronym: FOMO – “fear of missing out”. As the S&P500 enjoyed it best first quarter since 1998, the Nasdaq Composite returned 16.8%. Corporate credit posted big returns – investment-grade, junk and emerging markets. The Shanghai Composite jumped 24%, and China’s growth stock ChiNext Index surged 35%. The MSCI Emerging Markets index returned almost 10%. European stocks were up almost 12%, led by a 16% gain in Italian equities. European periphery bonds rallied, with Italian yields dropping 25 bps. It’s worth noting that Greek 10-year yields are down over 100 bps so far this year to near all-time lows. The Bloomberg Commodities Index increased 7.4% during Q1, led by a 40% surge in crude oil. And let’s not forget the collapse in safe haven sovereign yields – the melt-up in prices.
There are elements of this rally similar to late-2007. But in important respects, it recalls 1999. Back in ’99, speculative markets became convinced the Fed would not move to tighten financial conditions due to lingering global fragilities and the approaching Y2K issue. 1998 rate cuts were in response to global crisis fears, yet in reality the Fed was pouring fuel on bubbles that had been gaining momentum throughout the nineties – speculative bubbles along with a bubble economy.
Yet current bubble dynamics absolutely dwarf those from 1999. That bubble was largely confined to the U.S. technology sector – in the markets and economy. Today’s bubble dynamics envelop global markets – in the U.S., China, EM and Europe – as well as the entire unbalanced global economy. There are securities markets Bubbles across asset classes – equities, corporate Credit, sovereign debt and structured finance. The global leveraged speculating community is gargantuan compared to 1999; the $5 TN ETF industry didn’t even exist back then. The derivatives industry had a fraction of today’s global scope. And, importantly, Chinese finance and China’s economy – that today pose great systemic risk - were irrelevant in 1999.
I believe central bankers are deeply worried about the soundness of international finance and global economic structure. They worry that their tools may be incapable of averting the next crisis. They will, of course, never admit as much. This continues to be a monumental confidence game. Especially of late, central bankers point to the risk of inflation running below target - a strawman argument if there ever was one.
The evolution to globalized market-based finance has profoundly altered the nature of inflation. Undershooting CPI should no longer be a paramount issue – especially with the proliferation of new technologies, the digitization of so much “output,” the move to services-based economies and, of course, globalization. There is today a virtual endless supply of goods and services that exert downward pressure on aggregate consumer prices. Importantly, consumer price indices are no longer a reliable indicator of price stability, general monetary stability or the appropriateness of central bank policies.
I mentioned similarities to 1999. There are ominous parallels to 1929 as well. Concerns for downside consumer and commodities price pressures had in the late-twenties contributed to the Fed’s accommodation of increasingly speculative financial markets. And as late-cycle economic prospects began to dim, the Federal Reserve feared the consequences of piercing the stock market Bubble. When the bubble finally suffered its fate, the cataclysm set off the Great Depression.
Ben Bernanke was considered the nation’s foremost authority on the Great Depression when he was appointed Fed governor in 2002 following the bursting of the “tech” bubble. Dr. Bernanke believes the Great Depression was chiefly the consequence of the Fed failing to print enough money and reflate the system after the crash. He was determined to ensure the Fed never repeated this mistake.
But was the Great Depression primarily the result of post-crash policy mistakes - or instead was it the consequence of unsound money and credit and egregious “Roaring Twenties” excess? We are convinced of the later. The Fed thought THE bubble burst in 2001 and then again in 2008. And the problem with monetary stimulus and reflation is that once commenced it’s difficult if not impossible to rein in. We believe a decade of radical monetary measures will end terribly. I also believe we’re in the end-game – and it’s not a surprise that central bankers are increasingly desperate to avoid the cycle’s downside. Central banks are once again afraid of bursting historic bubbles. But their response to late-cycle fragilities and faltering booms only delays inevitable adjustments and corrections while worsening structural impairment.
We’re in a very dangerous period of globalized speculation and economic maladjustment. Central banks are no longer in control.
Central bankers are left to stoke excess, in fear of their decade-long monetary experiment blowing apart. China’s long experiment in state-directed economic and monetary management is similarly vulnerable. Their policy responses, as well, only further inflate their historic bubbles and intensify financial and economic fragilities.
The general view in the marketplace is one of incredible complacency: The Fed’s next move is to start cutting rates. They surely won’t tighten ahead of next year’s elections. In China, Beijing has concluded deleveraging and is now intent upon stimulating stronger economic growth. China’s Aggregate Financing expanded $1.22 TN during the first quarter, surely history’s greatest ever Credit expansion. The U.S. and China should soon ink a trade deal. And a pick up in the U.S. and China will underpin global growth recovery, or so bullish thinking goes.
What could go wrong? Why did the Nasdaq Bubble burst in Q1 2000? Why did stocks peak in the summer of 1929 a few short months ahead of catastrophe? It’s worth recalling that stocks surged to record highs right into the 1929 crash, the 1998 crisis, the 2000 tech bust and again in Q4 2007. Central bankers are once again afraid of addressing excess. But as we’ve witnessed repeatedly in the past, bubbles do eventually burst on their own accord and, when left to their own devices, their highly disruptive collapses come after years of cumulative distortion and structural impairment.
I didn’t begin posting the Credit Bubble Bulletin until 1999, but I was convinced in ‘98 the Fed was committing a major policy error. U.S. markets had turned highly speculative. Like today, the Fed and global central bankers were afraid of global fragilities. Yet markets and economies do turn progressively fragile after years of excess. Unfortunately, central bankers have not learned from their past mistake of fixating on fragility while accommodating dangerous booms. Slashing rates and orchestrating a bailout of LTCM only pushed the nineties bubble to “terminal excess.” I worry about what central bankers have unleashed with their recent ultra-dovishness in the face of historic late-stage global Bubble “terminal excess.”
The Fed and global central bankers have committed a similar mistake here in 2019 – except on a much grander scale. Today’s bubble is at a whole different level. It’s global, across the risk markets as well as throughout virtually all sovereign debt. Global economic imbalances are much more extreme. China’s bubble, surely history’s greatest, is - at - acute risk. Moreover, the global bubble has gone to the very foundation of global finance – central bank credit and government debt. Worst of all, the world is convinced central bankers have things well under control. Recalling pre-’98 crisis exuberance, markets were highly confident the West would never allow Russia to sink into financial crisis.
I’ll conclude this segment by highlighting a Bloomberg editorial earlier in the week from former head of the Federal Reserve Bank of Minneapolis, Narayana Kocherlakota: The Headline: “The Fed Needs to Fight the Next Recession Now. Its tools are limited, so the central bank must compensate by being aggressive.”
History will not be kind. Central bankers are afraid of global bubbles bursting and the revelation of epic policy failure. So they have become only more determined than ever to act early and aggressively. From the bubble perspective, this continues to follow the worst-case scenario.
The global bubble is today sustained by two crucial factors: faith in the all-powerful central bank community and confidence that Chinese officials can continue to orchestrate steady economic growth while maintaining financial stability. It’s a very different world when this confidence begins to wane.