http://prudentbear.com/index.php/creditbubblebulletinview?art_id=10676
The structure of today’s marketplace (especially with respect to the proliferation of hedging and derivative trading strategies) is conducive to short squeezes. This is compounded by the policy environment backdrop whereby market players (sophisticated and otherwise) fully recognize that policymakers are determined to backstop the markets. This incentivizes speculation and, I would argue, has nurtured Bubble Dynamics. Understandably, trumpeting global market resilience in the face of European debt tumult and slowing global growth has become common. I continue to fear that the confluence of complacency, policy impotence, and endemic global market speculative excess creates unappreciated systemic fragilities.
Extraordinarily divergent macro views have solidified. Some see the makings for a new secular bull market. I instead see an increasingly susceptible global Credit Bubble and attendant historic financial mania. A critical facet of this thesis remains that policymakers will go to incredible lengths to sustain Credit, financial and economic booms. And while this guarantees difficulty in assessing the timing of when catastrophe might strike – it seemingly ensures such an outcome. With unsettled markets only adding to confusion, I thought it appropriate this week to touch upon Credit theory to try to bring a little clarity to the muddled macro backdrop – Trying to Stay Focused on the Big Picture.
During the halcyon upside of the Credit cycle, ever increasing quantities of Credit disburse purchasing power throughout financial and economic systems. The Credit-induced increase in spending supports income growth, consumption, corporate profits, investment, government receipts/expenditures and economic output. Asset inflation is seen as fundamentally driven and, furthermore, as confirmation of the bullish viewpoint. One can say that Credit growth is self-reinforcing – or “recursive.” Importantly, the upside of Credit booms ensures seemingly positive “fundamentals” that validate the system’s financial asset price structures and, more generally, the expansive Credit and financial infrastructure.
The Credit boom ensures notions of economic “miracles,” “New Eras,” and “New Paradigms.” Policymakers are generally seen as astute; economic doctrine as advanced and enlightened. The inflationary bias associated with the Credit cycle’s upside provides policymakers great flexibility - and seemingly ensures policy effectiveness. And especially after a few episodes where policy responses free the system from the jaws of crisis, players throughout the markets and economy (not to mention the general public) come to believe in the capacity of policymakers to avoid trouble and sustain the boom. The social mood is one of general optimism, cooperation and cohesion. The pie is perceived to be getting bigger, and most are for the most part satisfied that they’re enjoying their fair share. And, of course, “bull markets create genius.”The unavoidable may be avoided for years, yet the brutality of a Credit cycle’s downside in the end will be commensurate with the duration and scope of boom-time excesses. And the changed Credit environment changes so many things. The maladjusted economic structure will eventually give way, ushering in a cycle of deteriorating fundamentals - including stagnant household incomes, faltering profits and deteriorating government finances. The pie will not only be shrinking, but most will come to see a fortunate few unfairly taking an ever increasing share to the detriment of everyone else. The system will be viewed as inequitable, unjust and flat out broken. The social mood turns sour, as most incomes stagnate (or worse) and perceived financial wealth withers. Faith in institutions will wane. Post-Bubble policymakers will invariably be viewed as inept. Optimism is supplanted by pessimism. As always, wrenching bear markets create disdain and hostility.
Credit’s downside, along with accompanying bear markets, over time instills wreaking ball havoc upon the Credit structure. In the final analysis, Credit is everything and always about confidence. During the Credit expansion, constructive fundamentals and general optimism bolster the perception that Credit is sound and that most Credit instruments will be vehicles of wealth generation. As a Credit bust ensues and the economic and asset price backdrop deteriorates, ever-increasing swaths of Credit instruments are viewed as impaired or even dubious. The entire Credit and financial structure, having grown to incredible stature during the boom, turns brittle and unstable – with trouble generally starting out on the “periphery” before eventually rotting away at the “core.”
Policymakers will not accept defeat without one hell of a fight. Dreadful policy errors will be repeated and compounded. Government officials will go to increasing inflationary lengths to bolster incomes and economic output, support asset markets, and stimulate Credit growth. Such measures typically enjoy initial success, though such a policy course will invariably lead to an expanding governmental role in the economy and an interventionist role in the Credit and asset markets. Too be sure, increasingly unsound finance will be mispriced and poorly allocated.
Stubborn refusal to admit policy mistakes along with increasing desperation ensure things will only get worse. Over time, it all regresses into a perilous confidence game. Government intervention and monetary stimulus inflate confidence for awhile, although such actions only weaken the underpinnings of the Credit structure. In reflecting upon the late-twenties excesses that set the stage for collapse and depression, Keynes referred to the “whirlwind of speculation.” I expect there will be a point when the markets begin to narrow the gulf between the (speculative) market’s perception of policy efficacy and the outright limits of governmental control and market intervention. “When the development of a country becomes the byproduct of the activities of a casino, the job is likely to be ill-done.”
Trying To Stay Focused On The Big Picture
- July 06, 2012
Having wrapped up my working holiday this week, my end-of-week writing schedule should now return to normal. It’s certainly been an eventful few weeks. The European debt crisis, again, began to spiral out of control. Policymakers were, once again, forced into desperate measures. Buffeted by countervailing forces, global risk markets have bounced between crisis-induced de-risking/de-leveraging and policy intervention-driven speculative excess. And as systemic stress escalates the markets anxiously anticipate even more powerful policy responses. The precarious “risk on, risk off” global market trading dynamic has become only more overbearing.
More specifically, global risk markets rallied significantly after Germany’s capitulation at the latest European summit. After stating rather unequivocally that there was a line that would not be crossed (“as long as I live”), Chancellor Merkel was seen as buckling under the pressure. The Germans gave into the demands (to some, “blackmail”) of the contingent from Italy, Spain and France, as the European powerbase lurched southward. And if Merkel was willing to bend on EU bailout oversight and emergency lending directly to Spanish banks, surely she would eventually capitulate on Eurobonds, EU system-wide deposit guarantees and other forms of debt “mutualization.” Those believing that the Germans would have no alternative than to eventually backstop troubled eurozone debt issuers were emboldened – at least momentarily.
Ms. Merkel was pilloried at home – by the press, by her political opposition and even within her own governing coalition. German public opinion is clearly hardening; the German constitutional court is preparing... And while it might appear that the June 28/29 summit provided an inflection point for a more pragmatic – and decidedly less principled - German position, one could also envisage a scenario where such public embarrassment engenders a tougher German stance. After dropping to 6.11% post-summit, Spanish 10-year yields traded back to almost 6.95% today. For the week, Spain’s 10-year yields jumped 62 bps and Italy’s rose 20 bps (to 6.01%).
In the (fleeting) post-summit euphoria, the euro rallied from about 1.24 to almost 1.27 (vs. the dollar). The euro ended this week at 1.2291, trading intraday below the June 1st trading low (1.2288). Considering the large short position, the euro bounce was notably unimpressive. Indeed, I view euro weakness as confirmation of the unfolding bearish thesis. The bullish contingent would like to view German policy accommodation as the beginning of the end to the European debt crisis. I (and others) instead see an escalating Credit crisis that has now irreparably afflicted the “core” of the European system. It is at this point wishful thinking to believe that the Germans – even if they were willing to sacrifice their nation’s creditworthiness to backstop eurozone debt – retain the capacity to sustain market confidence in Trillions of Spanish and Italian sovereign debt, local government obligations and banking system liabilities. Policymakers will, as we’ve witnessed again recently from European politicians and central bankers, respond to heightened systemic stress by ratcheting up their responses. Yet, and also no surprise, these increasingly desperate measures will have depleted and fleeting effects – and really tend only to heighten market instability. The big unknown remains the timing of when market confidence in the capacity of policy measures to incite market rallies is finally depleted. Without this carrot, I expect we’ll be facing an altered global market environment.
Ms. Merkel was pilloried at home – by the press, by her political opposition and even within her own governing coalition. German public opinion is clearly hardening; the German constitutional court is preparing... And while it might appear that the June 28/29 summit provided an inflection point for a more pragmatic – and decidedly less principled - German position, one could also envisage a scenario where such public embarrassment engenders a tougher German stance. After dropping to 6.11% post-summit, Spanish 10-year yields traded back to almost 6.95% today. For the week, Spain’s 10-year yields jumped 62 bps and Italy’s rose 20 bps (to 6.01%).
In the (fleeting) post-summit euphoria, the euro rallied from about 1.24 to almost 1.27 (vs. the dollar). The euro ended this week at 1.2291, trading intraday below the June 1st trading low (1.2288). Considering the large short position, the euro bounce was notably unimpressive. Indeed, I view euro weakness as confirmation of the unfolding bearish thesis. The bullish contingent would like to view German policy accommodation as the beginning of the end to the European debt crisis. I (and others) instead see an escalating Credit crisis that has now irreparably afflicted the “core” of the European system. It is at this point wishful thinking to believe that the Germans – even if they were willing to sacrifice their nation’s creditworthiness to backstop eurozone debt – retain the capacity to sustain market confidence in Trillions of Spanish and Italian sovereign debt, local government obligations and banking system liabilities. Policymakers will, as we’ve witnessed again recently from European politicians and central bankers, respond to heightened systemic stress by ratcheting up their responses. Yet, and also no surprise, these increasingly desperate measures will have depleted and fleeting effects – and really tend only to heighten market instability. The big unknown remains the timing of when market confidence in the capacity of policy measures to incite market rallies is finally depleted. Without this carrot, I expect we’ll be facing an altered global market environment.
The structure of today’s marketplace (especially with respect to the proliferation of hedging and derivative trading strategies) is conducive to short squeezes. This is compounded by the policy environment backdrop whereby market players (sophisticated and otherwise) fully recognize that policymakers are determined to backstop the markets. This incentivizes speculation and, I would argue, has nurtured Bubble Dynamics. Understandably, trumpeting global market resilience in the face of European debt tumult and slowing global growth has become common. I continue to fear that the confluence of complacency, policy impotence, and endemic global market speculative excess creates unappreciated systemic fragilities.
Extraordinarily divergent macro views have solidified. Some see the makings for a new secular bull market. I instead see an increasingly susceptible global Credit Bubble and attendant historic financial mania. A critical facet of this thesis remains that policymakers will go to incredible lengths to sustain Credit, financial and economic booms. And while this guarantees difficulty in assessing the timing of when catastrophe might strike – it seemingly ensures such an outcome. With unsettled markets only adding to confusion, I thought it appropriate this week to touch upon Credit theory to try to bring a little clarity to the muddled macro backdrop – Trying to Stay Focused on the Big Picture.
During the halcyon upside of the Credit cycle, ever increasing quantities of Credit disburse purchasing power throughout financial and economic systems. The Credit-induced increase in spending supports income growth, consumption, corporate profits, investment, government receipts/expenditures and economic output. Asset inflation is seen as fundamentally driven and, furthermore, as confirmation of the bullish viewpoint. One can say that Credit growth is self-reinforcing – or “recursive.” Importantly, the upside of Credit booms ensures seemingly positive “fundamentals” that validate the system’s financial asset price structures and, more generally, the expansive Credit and financial infrastructure.
The Credit boom ensures notions of economic “miracles,” “New Eras,” and “New Paradigms.” Policymakers are generally seen as astute; economic doctrine as advanced and enlightened. The inflationary bias associated with the Credit cycle’s upside provides policymakers great flexibility - and seemingly ensures policy effectiveness. And especially after a few episodes where policy responses free the system from the jaws of crisis, players throughout the markets and economy (not to mention the general public) come to believe in the capacity of policymakers to avoid trouble and sustain the boom. The social mood is one of general optimism, cooperation and cohesion. The pie is perceived to be getting bigger, and most are for the most part satisfied that they’re enjoying their fair share. And, of course, “bull markets create genius.”The unavoidable may be avoided for years, yet the brutality of a Credit cycle’s downside in the end will be commensurate with the duration and scope of boom-time excesses. And the changed Credit environment changes so many things. The maladjusted economic structure will eventually give way, ushering in a cycle of deteriorating fundamentals - including stagnant household incomes, faltering profits and deteriorating government finances. The pie will not only be shrinking, but most will come to see a fortunate few unfairly taking an ever increasing share to the detriment of everyone else. The system will be viewed as inequitable, unjust and flat out broken. The social mood turns sour, as most incomes stagnate (or worse) and perceived financial wealth withers. Faith in institutions will wane. Post-Bubble policymakers will invariably be viewed as inept. Optimism is supplanted by pessimism. As always, wrenching bear markets create disdain and hostility.
Credit’s downside, along with accompanying bear markets, over time instills wreaking ball havoc upon the Credit structure. In the final analysis, Credit is everything and always about confidence. During the Credit expansion, constructive fundamentals and general optimism bolster the perception that Credit is sound and that most Credit instruments will be vehicles of wealth generation. As a Credit bust ensues and the economic and asset price backdrop deteriorates, ever-increasing swaths of Credit instruments are viewed as impaired or even dubious. The entire Credit and financial structure, having grown to incredible stature during the boom, turns brittle and unstable – with trouble generally starting out on the “periphery” before eventually rotting away at the “core.”
Policymakers will not accept defeat without one hell of a fight. Dreadful policy errors will be repeated and compounded. Government officials will go to increasing inflationary lengths to bolster incomes and economic output, support asset markets, and stimulate Credit growth. Such measures typically enjoy initial success, though such a policy course will invariably lead to an expanding governmental role in the economy and an interventionist role in the Credit and asset markets. Too be sure, increasingly unsound finance will be mispriced and poorly allocated.
Stubborn refusal to admit policy mistakes along with increasing desperation ensure things will only get worse. Over time, it all regresses into a perilous confidence game. Government intervention and monetary stimulus inflate confidence for awhile, although such actions only weaken the underpinnings of the Credit structure. In reflecting upon the late-twenties excesses that set the stage for collapse and depression, Keynes referred to the “whirlwind of speculation.” I expect there will be a point when the markets begin to narrow the gulf between the (speculative) market’s perception of policy efficacy and the outright limits of governmental control and market intervention. “When the development of a country becomes the byproduct of the activities of a casino, the job is likely to be ill-done.”
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