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The makings for a major top – Doug Noland

by Doug Noland

The thesis has been that unconstrained global credit inherently fuels serial boom and bust cycles. In particular, the dramatic policy response to the 2008/09 collapse of the mortgage finance bubble incited unprecedented financial and economic excess in China and throughout the ”developing” economies.

Double-digit credit growth has been compounding over recent years in China, Brazil, India, Turkey and, generally, throughout Asia and Latin America. I have referred to such a late-cycle dynamic as the ”terminal phase” of credit bubble excess.

For going on five years now, unprecedented ”hot money” has inundated emerging market (EM) financial systems and economies. And as ”money” flooded in, EM central banks ”recycled” much of this liquidity right back into US Treasuries, German bunds, and sovereign debt around the world. This massive flow of finance into EM also spurred a spectacular expansion in sovereign wealth funds (SWF), hedge funds and the ”global leveraged speculating community” more generally.

The rapid growth in both EM central bank reserve assets, as well as the global pool of speculative finance, solidified the perception of unlimited cheap global liquidity. Repeated – and increasingly desperate – central bank measures over recent years have further crystallized the perception that global markets enjoy a powerful liquidity backstop. Accordingly, speculation has run roughshod through the global markets.

A strong case can be made that recent years have seen the greatest episode of global securities mispricing in history. Global yields collapsed throughout, although nowhere has this mispricing been more pronounced than with EM bond markets.

For example, Brazilian (dollar-denominated) bond yields collapsed from above 25% in 2002 to a record low 2.5% last year (currently 4.8%). After averaging about 7% for the period 2003-2011, Turkish (dollar-denominated) bond yields sank to a record low 3.17% in November 2012 (currently 5.6%). After last year sinking to record low 2.84%, Indonesian dollar bond yields have jumped back to 6.12%.

The bullish EM case has been premised on superior fundamentals compared to the developed world. The bear case is that EM markets have been at the heart of historic bubble excess. I posit that EM securities markets have provided the most extreme case of misperceptions, speculative excess and a general mispricing of risk throughout. I would further argue that the EM bubble has begun to burst.

Moreover, I would expect that global markets have likely commenced a problematic ”periphery” to ”core” credit and economic crisis – where risk aversion, de-leveraging and resulting liquidity issues gravitate from one market to the next. This dynamic has been held somewhat at bay by massive Fed and Bank of Japan quantitative easing and the liquidity backstop of European Central Bank president Mario Draghi.

So far in 2013, the Brazilian real has declined 12.66% and the Argentine peso 12.59%. India’s rupee has dropped 13.25%. The Turkish lira is down 10.26%, the Indonesia rupiah 11.44%, the Malaysian ringgit 7.35%, and the Thai baht 3.96%. The South African rand has lost 17.28% and the Russian rouble 7.51%.

Over the past three months, the Brazilian real has declined 12.98%, the Indian rupee 12.32%, the Indonesian rupiah 11.53%, the Malaysian ringgit 8.10%, the Turkish lira 7.11%, the South African rand 6.98%, the Argentine peso 6.42%, the Thai baht 6.09% and the Philippine peso 5.63%.

Market action in recent months has caught many participants be surprise, including some of the most sophisticated market operators. In particular, instead of rallying on heightened EM instability, ”core” sovereign bonds have been hit by unexpected selling pressure. Treasury yields have surged 82 basis points during the past three months and bund yields have jumped 50 bps. Recent atypical correlations between ”core” (perceived safe haven) bonds and EM risk markets have thrown a monkey wrench into many investment/speculation strategies (including variations of popular ”risk parity” models). …

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