Doug Noland: The Road to Normalization

This is a syndicated repost courtesy of Credit Bubble Bulletin . To view original, click here. Reposted with permission.

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The past week provided important support for the “peak monetary stimulus” thesis. There is mounting evidence that global central bankers are monitoring inflating asset prices with heightened concern. The intense focus on CPI is beginning to blur. They would prefer to be on a cautious path toward policy normalization.

June 25 – Financial Times (Claire Jones): “Global financial stability will be in jeopardy if low inflation lulls central banks into not raising interest rates when needed, the Bank for International Settlements has warned. The message about the dangers of sticking too closely to inflation targets comes as central banks in some of the world’s largest economies are considering how to end years of ultra-loose monetary policy after the global financial crisis… ‘Keeping interest rates too low for long could raise financial stability and macroeconomic risks further down the road, as debt continues to pile up and risk-taking in financial markets gathers steam,’ the bank said in its annual report. The BIS acknowledged that raising rates too quickly could cause a panic in markets that have grown used to cheap central bank cash. However, delaying action would mean rates would need to rise further and faster to prevent the next crisis. ‘The most fundamental question for central banks in the next few years is going to be what to do if the economy is chugging along well, but inflation is not going up,’ said Claudio Borio, the head of the BIS’s monetary and economics department… ‘Central banks may have to tolerate longer periods when inflation is below target, and tighten monetary policy if demand is strong — even if inflation is weak — so as not to fall behind the curve with respect to the financial cycle.’ …Mr Borio said many of the factors influencing wage growth were global and would be long-lasting. ‘If, as we think, the forces of globalisation and technology are relevant [in keeping wages low] and have not fully run their course, this will continue to put downward pressure on inflation,’ he said.”

While global markets easily ignored ramifications from the BIS’s (the central bank to central banks) annual report, the same could not be said for less than super dovish comments from Mario Draghi, my nominee for “the world’s most important central banker.”

June 27 – Financial Times (Katie Martin): “What’s that, you say? The ‘R-word’? Judging from the markets, Mario Draghi’s emphasis on reflation changes everything, and highlights the communications challenge lying ahead of the president of the European Central Bank. The ECB’s crisis-fighter-in-chief threw investors into a fit of the vapours on Tuesday when he said he was growing increasingly confident in the currency bloc’s economic recovery, and that ‘deflationary forces have been replaced by reflationary ones’.”

June 27 – Bloomberg (Annie Massa and Elizabeth Dexheimer): “Mario Draghi hinted at how he may sell a gradual unwinding of European Central Bank stimulus. The ECB president repeated his mantra that the Governing Council needs to be patient in letting inflation pressures build in the euro area and prudent in withdrawing support. At the same time, there’s room to tweak existing measures. ‘As the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments — not in order to tighten the policy stance, but to keep it broadly unchanged.’ The comments echo an argument first made by Bundesbank President Jens Weidmann… With his nod to a frequent critic of quantitative easing who has been calling for an end of the 2.3 trillion-euro ($2.6 trillion) program, Draghi may have set the stage for a discussion in the coming months on phasing out asset purchases.”

When the ECB chose not to offer any policy clarification coming out of its June 8th meeting, wishful markets had Draghi holding out until September. The timeline was moved up, with the ECB president using the bank’s annual meeting, held this year in Sintra Portugal, to offer initial thoughts on how the ECB might remove accommodation. Market reaction was swift.

German 10-year bund yields surged 13 bps Tuesday and almost doubled this week to 47bps. French yield jumped 14 bps Tuesday – and 21 bps for the week – to 82 bps. European periphery bonds were under pressure. Italian 10-year yields rose 16 bps Tuesday and 24 bps for the week to 2.16%. Portuguese yields rose 14 bps Tuesday, ending the week at 3.03%. Draghi’s comments rattled bond markets around the globe. Ten-year Treasury yields rose seven bps to 2.21% (up 16 bps for the week), Canadian bonds 11 bps to 1.57% and Australian bonds 10 bps to 2.46%. Emerging market bonds also came under heavy selling pressure, with Eastern European bonds taking a pounding.

June 28 – Bloomberg (Robert Brand): “This is what it sounds like when doves screech. Less than 24 hours Mario Draghi jolted financial markets by saying ‘deflationary forces’ have been replaced by reflationary ones, European Central Bank officials reversed the script, saying markets had misinterpreted the central banker’s comments. What was perceived as hawkish was really meant to strike a balance between recognizing the currency bloc’s economic strength and warning that monetary support is still needed, three Eurosystem officials familiar with policymakers’ thinking said. Their dovish interpretation sparked a rapid unwinding of moves in assets from the euro to stocks and sovereign bonds.”

I don’t see it as the markets misinterpreting Draghi. Understandably, inflated Bubble markets have turned hyper-sensitive to the course of ECB policymaking. The ECB’s massive purchase program inflated a historic Bubble throughout European debt markets, a speculative Bubble that I believe unleashed a surge of global liquidity that has underpinned increasingly speculative securities markets.

If not for massive QE operations from the ECB and BOJ, I believe the 2016 global reversal in bond yields would have likely ushered in a major de-risking/deleveraging episode throughout global markets. Instead, powerful liquidity injections sustained speculative Bubbles throughout global fixed income, in the process spurring blow-off excess throughout global equities and risk assets more generally. Recalling the summer of 2007, everyone is determined to see the dance party rave indefinitely.

First-half QE has been estimated (by Bank of America) at (an incredible) $1.5 TN. Bubbling markets should come as no stunning surprise. At May highs, most European equities indices were sporting double-digit year-to-date gains. The S&P500 returned (price + dividends) almost 10% for the first half, with the more speculative areas of U.S. equities outperforming. The Nasdaq Composite gained 14.1%, with the large company Nasdaq 100 (NDX) rising 16.1%. Despite this week’s declines, the Morgan Stanley High Tech index rose 20.3%, and the Semiconductors (SOX) jumped 14.2% y-t-d. The Biotechs (BTK) surged 9.7% during Q2, boosting y-t-d gains to 25.6%. The NYSE Healthcare Index gained 7.7% for the quarter and 15.3% y-t-d. The Nasdaq Transports jumped 9.7% during Q2, with the DJ Transports up 5.3%. The Nasdaq Other Financials rose 7.9% in the quarter.

Central banks have closely collaborated since the financial crisis. While always justifying policy stimulus on domestic grounds, it’s now been almost a decade of central bankers coordinating stimulus measures to address global system fragilities. I doubt the Fed would have further ballooned its balance sheet starting in late-2012 if not for the “European” financial crisis. In early-2016, the ECB and BOJ would not have so aggressively expanded QE programs – and the Fed not postponed “normalization” – if not for global ramifications of a faltering Chinese Bubble. All the talk of downside inflation risk was convenient cover for global crisis worries.

As Mario Draghi stated, the European economy is now on a reflationary footing. At least for now, Beijing has somewhat stabilized the Chinese Bubble. Powered by booming securities markets, global Credit continues to expand briskly. Even in Europe, the employment backdrop has improved markedly. It’s just become difficult for central bankers to fixate on tame consumer price indices with asset prices running wild.

Global market liquidity has become fully fungible, a product of multinational financial institutions, securities lending/finance and derivatives markets. The ECB and BOJ’s ultra-loose policy stances have worked to counteract the Fed’s cautious normalization strategy. Determined to delay the inevitable, Draghi now faces the scheduled year-end expiration of the ECB’s latest QE program, along with an impending shortage of German bunds available for purchase. Behind the scenes and otherwise, Germany is surely losing patience with open-ended “money” printing. This week’s annual ECB gathering provided an opportunity for Draghi to finally get the so-called normalization ball rolling. Despite his cautious approach, markets immediately feared being run over.

June 28 – Bloomberg (Alessandro Speciale): “Mario Draghi just got evidence that his call for ‘prudence’ in withdrawing European Central Bank stimulus applies to his words too. The euro and bond yields surged on Tuesday after the ECB president said the reflation of the euro-area economy creates room to pull back unconventional measures without tightening the stance. Policy makers noted the jolt that showed how hypersensitive investors are to statements that can be read as even mildly hawkish… Draghi’s speech at the ECB Forum in Sintra, Portugal, was intended to strike a balance between recognizing the currency bloc’s economic strength and warning that monetary support is still needed, said the officials…”

June 28 – Bloomberg (James Hertling, Alessandro Speciale, and Piotr Skolimowski): “Global central bankers are coalescing around the message that the cost of money is headed higher — and markets had better get used to it. Just a week after signaling near-zero interest rates were appropriate, Bank of England Governor Mark Carney suggested on Wednesday that the time is nearing for an increase. His U.S. counterpart, Janet Yellen, said her policy tightening is on track and Canada’s Stephen Poloz reiterated he may be considering a rate hike. The challenge of following though after a decade of easy money was highlighted by European Central Bank President Mario Draghi’s attempt to thread the needle. Financial markets whipsawed as Eurosystem officials walked back comments Draghi made Tuesday that investors had interpreted as signaling an imminent change in monetary policy. ‘The market is very sensitive to the idea that a number of central banks are appropriately and belatedly reassessing the need for emergency policy accommodation,’ said Alan Ruskin, co-head of foreign exchange research at Deutsche Bank AG.”

Draghi and the ECB are hoping to duplicate the Fed blueprint – quite gingerly removing accommodation while exerting minimal impact on bond yields and risk markets more generally: Normalization without a meaningful tightening of financial conditions. This is unrealistic.

Current complacency notwithstanding, turning down the ECB QE spigot will dramatically effect global liquidity dynamics. Keep in mind that the removal of Fed accommodation has so far coincided with enormous counteracting market liquidity injections courtesy of the other major central banks. The ECB will not enjoy a similar luxury. Moreover, global asset prices have inflated significantly over the past 18 months, fueled at least in part by a major increase in speculative leverage.

There are three primary facets to QE dynamics worth pondering as central banks initiate normalization. The first is the size and scope of previous QE operations. The second is the primary target of liquidity-induced market flows. And third, to what extent have central bank measures and associated market flows spurred self-reinforcing speculative leveraging and market distortions. Inarguably, ECB and BOJ-induced flows over recent quarters have been massive. It is also reasonably clear that market flows gravitated primarily to equities and corporate Credit, asset classes demonstrating the most enticing inflationary biases. And there are ample anecdotes supporting the view that major speculative leveraging has been integral to myriad Bubbles throughout global risk markets. The now deeply ingrained view that the cadre of global central banks will not tolerate market declines is one of history’s most consequential market distortions.

And while the timing of the removal of ECB and BOJ liquidity stimulus remains uncertain, markets must now at least contemplate an approaching backdrop with less accommodation from the ECB and central banks more generally. With this in mind, Draghi’s comments this week could mark an important juncture for speculative leveraging. Increasingly unstable currency markets are consistent with this thesis. The days of shorting yen and euros and using proceeds for easy profits in higher-yielding currencies appear to have run their course. I suspect de-leveraging dynamics have commenced, though market impact has thus far been muted by ongoing ECB and BOJ liquidity operations.

June 27 – Reuters (William Schomberg, Marc Jones, Jason Lange and Lindsay Dunsmuir): “U.S. Federal Reserve Chair Janet Yellen said on Tuesday that she does not believe that there will be another financial crisis for at least as long as she lives, thanks largely to reforms of the banking system since the 2007-09 crash. ‘Would I say there will never, ever be another financial crisis?’ Yellen said… ‘You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be,’ she said.”

While headlines somewhat paraphrased Yellen’s actual comment, “We Will not see Another Crisis in Our Lifetime” is reminiscent of Irving Fisher’s “permanent plateau” just weeks before the great crash of 1929. While on the subject, I never bought into the popular comparison between 2008 and 1929 – and the related notion of 2008 as “the 100-year flood”. The 2008/09 crisis was for the most part a private debt crisis associated with the bursting of a Bubble in mortgage Credit – not dissimilar to previous serial global crises, only larger and somewhat more systemic. It was not, however, a deeply systemic debt crisis akin to the aftermath of 1929, which was characterized by a crisis of confidence in the banking system, the markets and finance more generally, along with a loss of faith in government policy and institutions. But after a decade of unprecedented expansion of government debt and central bank Credit, the stage has now been set for a more systemic 1929-like financial dislocation.

As such, it’s ironic that the Fed has branded the banking system cured and so well capitalized that bankers can now boost dividends, buybacks and, presumably, risk-taking. As conventional central bank thinking goes, a well-capitalized banking system provides a powerful buffer for thwarting the winds of financial crisis. Chair Yellen, apparently, surveys current bank capital levels and extrapolates to systemic stability. Yet the next crisis lurks not with the banks but in the securities and derivatives markets: too much leverage and too much “money” employed in trend-following trading strategies. Too much hedging, speculating and leveraging in derivatives. Market misperceptions and distortions on an epic scale.

Compared to 2008, the leveraged speculating community and the ETF complex are significantly larger and potentially perilous. The derivatives markets are these days acutely more vulnerable to liquidity issues and dislocation. Never have global markets been so dominated by trend-following strategies. It’s a serious issue that asset market performance – stocks, bond, corporate Credit, EM, real estate, etc. – have become so tightly correlated. There are huge vulnerabilities associated with various markets having become so highly synchronized on a global basis. And in the grand scheme of grossly inflated global securities, asset and derivatives markets, the scope of available bank capital is trivial.

I realize that, at this late stage of the great bull market, such a question sounds hopelessly disconnected. Yet, when markets reverse sharply lower and The Crowd suddenly moves to de-risk, who is left to take the other side of what has become One Gargantuan “Trade”? We’re all familiar with the pat response: “Central banks. They’ll have no choice.” Okay, but I’m more interested in the timing and circumstances.

Central bankers are now signaling their desire to proceed with normalization, along with noting concerns for elevated asset prices. As such, I suspect they will be somewhat more circumspect going forward when it comes to backstopping the markets – than, say, back in 2013 with Bernanke’s “flash crash” or with the China scare of early-2016. Perhaps this might help to explain why the VIX spiked above 15 during Thursday afternoon trading. Even corporate debt markets showed a flash of vulnerability this week.

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