In Terminal Velocity “Normalization?”, it was suggested that the Fed is in the process of Normalizing the term structure of interest rates whilst its balance sheet remains expanded. The “Taper” and the communication policy in relation to it can be understood as tools to achieve this Normalization. We said:
A normal term structure of interest rates and hence the normal pricing of investment risk is needed to stimulate capital investment. Higher interest rates create the reward, which can then be adjusted for the risks being taken to achieve it.
NOTE: A move to this normal structure of interest rates will not be without volatility; so the Fed intends to maintain an expanded balance sheet to absorb much of this volatility (aka the mark to market losses on assets).
Market analysts and commentators are now starting to talk about how the Fed is managing the volatility associated with the Normalization. Sober Look provided a good summary of this analysis[i]. Basically, the Fed is providing a bid for the US Treasuries that Convexity Sellers need to sell, to hedge their mortgage portfolios against a back-up in yields. This implies that the Fed is taking a mark-to-market hit on its existing MBAS and also on its Treasuries, by paying up so the Convexity Sellers get a nice hedge price. The Fed is now manipulating duration and convexity by setting artificial prices at which it will pay up for MBAS and Treasuries. From our perspective, this confirms the thesis outlined in these Terminal Velocity discussions, which suggests that the Fed is engaged in a micro-monetary policy that has macroeconomic outcomes. There is an implied cost in this volatility management, which is represented by the mark-to-market loss created on the Fed’s balance sheet. This cost is increased when the Fed pays up for assets, as the hedgers and speculators liquidate. Market prices for securities are established by the Fed’s backstop bids, but these are far from real value implied by the bond math that calculates prices based on duration, convexity and hedge ratios. The Fed’s unrealized loss is Wall Street’s gain; so once again we see the Fed rescuing the financial community. This time, one suspects that the Fed genuinely believes that it is saving the economy however!
Another tool that has been less successful in managing the volatility is the communication from the Fed. This tool has been undermined by dissonance and lack of consensus on QE and the exit. Bill Dudley said markets would overreact to news of the “Taper”[ii]; however it was down to the policy tool known as Jon Hilsenrath to be more explicit in begging the markets not to sell off[iii]. It is not seemly for Fed officials to be seen to be begging speculators to buy.
To understand how we got here, it is useful to go back a little further to see this Normalization strategy emerging.
In Terminal Velocity “Minds and Hands on the Joystick”, the elevated concern shown by Bernanke for the level of Risk Assets was noted. In his speech at the 49th Annual Conference on Bank Structure and Competition sponsored by the Federal Reserve Bank of Chicago, entitled Monitoring the Financial System[iv], he was very specific about the risks building in the capital markets, when he said:
“The apparent tendency for financial market participants to take greater risks when macro conditions are relatively stable. Indeed, it may be that prolonged economic stability is a double-edged sword”.
Bernanke was preparing the markets for a period of volatility associated with the Normalization process.
Bill Dudley then followed up, to frame the issue and the expected volatility in the capital markets. In Terminal Velocity “Real Interesting”, his speech to the Japan Society was seen as the context for the ensuing volatility in Japanese interest rates, which started the Beta correction in Risk Assets[v]. Dudley warned that the markets would overreact; and the markets did overreact.
The May Employment Situation Report seemed to restore calm. This calm was associated with what market practitioners have termed the “Goldilocks Economy” in previous bubbles. Loosely understood, the “Goldilocks Economy” is one characterised by weak economic growth and abundant central bank liquidity. This scenario is one in which Risk Assets flourish, because there is no apparent end in sight to both the weak growth and the abundant liquidity. It is in these conditions that bubbles are created, because investors think it will never end. Consequently, after the employment report was released, the Equity Markets swiftly moved higher to discount the “Goldilocks” scenario. What was notable however was that the Bond Markets and the Gold Market remained very circumspect. The circumspection was underlined, when the Fed policy tool known as Jon Hilsenrath wrote that the Fed will be announcing the “Taper” at its June meeting, after the euphoria over the Jobs Number had started to move equities back into the bubble zone that originally upset Bernanke[vi]. The whole episode was provided with a full-stop by Standard and Poor’s on the following Monday; when they opined that they were upgrading America’s debt outlook to stable from negative. S&P broke with tradition and released their statement before the market opened, so that traders could discount the good news by supporting Treasuries. This faits accomplis fooled no-one; and actually marked the top of the dead-cat bounce after the Jobs Number. On reflection, Bernanke decided that the markets were still too vulnerable; so he enlisted Hilsenrath to feed them some more porridge after the release of the May Retail Sales report. The US capital markets are so rigged by the Fed at this point in time that it beggars belief; but traders seem to fall for it every day as they discount the nuances from the Fed. Whilst this manipulated dynamic equilibrium is being established, global markets are imploding. For once, the global markets are actually signalling where the US should be going. Strategists are opining the wisdom of the “Long US and Short the Rest” trade; and the US Dollar is rallying. The problem with this is that the “Long US” component is being artificially manipulated by the Fed. US markets are therefore becoming extremely over-valued relative to global markets. One should be “Short the Rest and Shorter the US”!!!
Looking back at the chain of events, from Bernanke’s Chicago Speech to the Employment Report, one is supposed to conclude that the Risk Asset Bubble has been deflated. The above Bloomberg snapshot of the S&P, Investment Grade Bond and High Yield Bond ETFs emphatically confirms this. Readers who believe in coincidence may wish to pause and think. A deflation of the Risk Asset Bubble was attempted; but it failed to convince the holders of Treasuries to be satisfied with the current yield cushion. It also failed to convince global investors that the worst was over. The Fed is standing there, with an over-valued bid and a communication strategy that is telling people that on the one hand it is “Tapering” but on the other hand the market has great value. Global investors will call the Fed’s bluff; and we suspect that it will be Japanese investors who are the first to do so. Japanese investors have taken huge losses on their bond-holdings after the announcement of the 2% inflation target. They were cushioned by gains on their Japanese equities, so some equity liquidations were made to provide liquidity for the bond losses. This equity liquidation caused a rout. Sales of European bonds were also made to provide liquidity to be repatriated. The rally in European bonds and euphoria over the end of the crisis there, abruptly ended with the pulling of Japanese liquidity. It is fair to say that the euphoria and lower yields in Europe had more to do with the BOJ than he ECB. Now the game is over; and Europe will implode as the resolution of its banking crisis combines with the removal of Japanese liquidity. All this can be traced back to the Fed signalling the “Taper”; and causing an uptick in real interest rates.
As a consequence, US Treasury Volatility remains elevated; and holds the global capital markets to ransom. This directly translates into an increase in Volatility of the Yen; and Yen denominated assets. US Treasury Yields and the Yen are both flashing warning signals.
Readers should also take a big pinch of salt with the “Porridge” that the “Goldilocks” storytellers are telling. Two Volumes of this story have been read since it became a best-seller in 1994. They have both ended in bubbles and violent corrections. We would suggest that Volume III is now being published on Wall Street. For those readers who like to dabble in charts, we would observe that the first graph (Total Housing Net Worth as a % age of GDP, above) that we have used to illustrate this fairy tale, may be forming what is known as a “Head and Shoulders” pattern. If this pattern is completed, it will illustrate a secular trend in the capital markets that is reversing. This would signal the end of the driving force of the financial sector in the economy of the United States.
In Terminal Velocity “Normalization?”, it was observed that the Fed’s Bloom Raskin and Plosser have a plan to apply Basel III in a very simplistic fashion to the banking system. This application would effectively end the driver and the risk associated with the financial sector in the US economy. It was also observed that Bernanke was abandoning the anachronism that is known as QE, in favour of a strategy that focuses on the Employment Mandate; and that may lead to a return of Inflation. The reversal signal from the technical analysis is therefore based in the fundamental analysis of the change in Fed strategy and behaviour.
In Terminal Velocity “Normalization?” it was also stated that the Fed has succeeded in addressing the liquidity crisis; however that there remains a lingering solvency crisis which cannot be addressed with more liquidity. Only growth, bankruptcy or, failing these two, inflation can be the ultimate solutions to the solvency issue. We suggest that, with ample liquidity in the financial system, the Fed is now opening up the solvency issue.
Policy makers in Developed Markets have been opining the need to balance the Global Economy since the crisis started. So far nothing has happened on the rebalancing issue; and there has been a tendency towards national protectionist solutions that hint at Trade Wars. Clearly, rebalancing is not going to happen; because there is no global consensus. Policy makers in the Developed Markets are therefore going to act unilaterally. It was amusing to hear Stanley Fisher, himself a candidate for the fed Chair, spin the positive outcome of this scenario.
According to his sophistry, rising US real interest rates and the rising US Dollar will prevent the currency wars that will destabilize the global economy. In practice however, Emerging Economies will have to raise interest rates to stem capital outflows. Since they have higher inflation rates than Developed Markets, they will have to raise interest rates by more than the Fed. Brazil is a classic case study of this issue; it is now raising interest rates because it has inflation and a currency crisis[vii]. “Beggar thy Neighbour” currency manipulation is now replaced with “Beggar thy Neighbour tightening”[viii]. Deflation is baked in globally. Many commentators are saying that the American market is at a point similar to 1994, when a sharp uptick in interest rates triggered a large sell-off. Other commentators are saying that the Emerging Markets look like 1998 again. Stanley Fischer has eloquently combined the two scenarios, with a speech that is supposed to restore calm to both. He seems to be a job candidate for the Fed Chair, cut from the same cloth as Alan Greenspan. Greenspan’s signature was the use of sophistry to eloquently disguise inherently unstable situations. It is instructive to understand how Developed Markets came to this position. Developed Market economies have evolved following the pattern of Exter’s Inverted Pyramid.
Each growth stage in the economy is associated with the creation of new layers of debt instruments. The debt instruments have grown larger than the real economy, because the concept of leverage has been enshrined and institutionalised in them. Normal debt is based on income and ability to cover interest cost with this income. Leverage involves the ability to use a debt instrument as the collateral for another asset purchase. A leveraged debt is taken out to finance the creation of a capital gain in the asset purchased. Leverage occurs at very low rates of interest; because the borrowing cost is small. Assets bought through leverage, will then experience a fall in yield which begins to approach the level of the interest cost associated with the debt. As long as the capital gain is expected to be greater than the interest cost, leverage will “appear” to be attractive. A pyramid of leverage is therefore built into Exter’s Inverted Pyramid. This leverage pyramid is more volatile; since it depends upon the price volatility of the assets purchased. Leverage therefore destabilizes Exter’s Pyramid; and in so doing destabilizes the Credit Cycle and Business Cycle that are based on Exter’s Pyramid.
We would suggest that leverage is what has allowed the levels in Exter’s Pyramid to grow larger than the underlying GDP in a Developed Economy. The financial sector therefore becomes the largest component in a Developed Economy through leverage. The real economy in Developed Markets also grows at a slower rate as the economies mature. The gap between the real economies and their financial sectors therefore gets wider as the economies mature. When the financial sectors are larger than the real economies, they develop a life of their own that we will call the Leverage Cycle. Characters associated with the preservation of this Leverage Cycle are installed in executive branches of finance and government policy. Firms like JP Morgan, Goldman Sachs and Citigroup are quite likely to have employed these executives at some time. Stanley Fischer for example is ex pre-Crisis Citigroup; and perhaps the most famous was ex-Goldman Secretary Paulson. Bernanke is however untainted; and always seems ill at ease with being held to ransom by these operators. The financial sector effectively captures the economy and the government. The phenomenon known as Too Big to Fail is the poster child of this situation; and the Bailout resulting from the Credit Crunch is the living proof.
Source: TBNTF (Too Big Not to Fail) @ Pinterest
Primary Source: Derivatives: The Unregulated Global Casino for Banks
This Leverage Cycle should not be confused with the Business Cycle or Credit Cycle. The Leverage Cycle is a derivative of the Credit Cycle; and it is also pro-Cyclical in relation to it. The Leverage Cycle thus creates bubbles in an expanding Credit Cycle and crashes in a declining Credit Cycle. The Leverage Cycle is also pro-Cyclical in relation to the Business Cycle. We would argue that since 1994, the Fed has become increasingly more involved in addressing the Leverage Cycle than either the Credit Cycle or Business Cycle. The Fed’s solution has been the supply of emergency liquidity to restart the Leverage Cycle after a contraction. Each injection of liquidity has led to the creation of more layers in the Pyramid, ultimately resulting in the growth of derivatives. Derivatives volumes are now way in excess of the volumes of GDP related transactions in Developed Economies. Today, the layer referred to as Derivatives has become the greatest systemic threat to the economy.
Having now understood that they have been slaves of the Leverage Cycle, the Fed is trying to wrest control of the various layers of the Leverage Cycle in Exter’s Pyramid from those known as the “Banksters”. The expanded balance sheet and the application of Basel III are logical steps being taken on the path to control of the Leverage Cycle. The Fed becomes the largest player in each Leverage Layer of the Pyramid, so that it controls the prices in it. Control is applied through the collateral markets associated with the leverage in each instrument. Basel III Rules, in relation to capital buffers for each asset class, set limits on how much leverage the banks can take. The Fed is attempting to control the volatility associated with the Leverage Cycle.
There is also a strong reason for the Fed to control the Leverage Cycle and re-engage with the Business Cycle. Developed Economies that are maturing are prone to Deflation.
Japan is the epitome of this phenomenon.
Emerging Markets with youthful demographics are more prone to credit creation; and inflation consummate with their faster growth dynamics. As economies mature, populations have a tendency to age and focus on creating savings rather than procreating more children to ensure their posterity. Economic policies in Emerging Economies therefore follow those in Developed Economies as they begin to mature. It is therefore impossible for the classical global rebalancing that the Developed Market policy makers call for to occur. Today’s Emerging Markets will be tomorrow’s savers. As they become savers, it is very unlikely that they will buy exports from Developed Markets. The recycling of the Chinese Trade Surplus back into US Treasuries stands out as something else visible from space in China. It signifies that rapidly aging China has already made the quantum shift to become the new Japan. The bubbles in Chinese assets are also signals that the rapidly aging Chinese are trying to create savings at any price.
There is thus a secular trend in place for all global economies to mature and become savers. This means that there is a strong secular trend towards Deflation in the global economy. This trend gets reinforced by politicians, because they will adopt a tendency to preserve savings and hence their aging voters’ franchise. For the young voters, there is no other game in town; other than to get rich quick or die trying, by getting educations that will allow them to play the savings game. The politicians preserve savings and the central bankers preserve leverage. These preservations get called what is known as the “Goldilocks Economy”.
We suspect that Japan, followed by America have come to the conclusion that they have a Deflation problem before their peers. Europe is still going through the pain of preserving aging German savers at the expense of young unemployed Southern Europeans; until this modality breaks. Emerging Markets are at various stages of balancing the savings of the newly emerged Middle Class against the need for economic growth of the masses. As we concluded, in Terminal Velocity “Normalization?”, the only way out is via growth, insolvency or inflation. These are the choices that must be made by politicians, judges and the voters. We suspect that the Fed has decided that more leverage is now making the whole system more risky; so that it has decided to pass the parcel back into the political and legal spheres. Our suspicion is also that these two spheres will prevaricate and force the Fed to come up with an old policy option named Inflation.