http://www.prudentbear.com/2013/04/the-global-reflation-trade.html#more
The Global Reflation Trade
April 26, 2013
Global markets are nothing if not unstable.
April 26 – Financial Times (Michael Steen): “Germany’s Bundesbank has criticised the bond-buying programme designed by the European Central Bank to save the euro, questioning whether it is really necessary and suggesting it represents a great risk to taxpayers. Bundesbank president Jens Weidmann has been public from the outset in his institution’s opposition to the Outright Monetary Transactions programme launched in September by Mario Draghi, ECB president, after pledging to do ‘whatever it takes’ to save the euro. But revealed in an opinion written by the Bundesbank for the German constitutional court are a series of detailed objections to the plan…”
April 26 – Bloomberg (Jana Randow): “The Bundesbank criticized the European Central Bank’s bond-buying plan in an opinion for Germany’s Constitutional Court, saying diverging interest rates within the euro region aren’t necessarily something the ECB should fix. ‘Even though monetary policy is having different effects within the euro area, it is questionable whether these differences constitute a malfunctioning to be addressed by monetary policy,’ the Bundesbank wrote in an opinion… dated Dec. 21… Rising sovereign bond yields ‘cannot be used definitively as an explanation for a disturbance of monetary- policy transmission,’ the Bundesbank opinion says. Germany’s top court has scheduled hearings for June 11 and 12 to look into cases challenging the nation’s participation in the European Stability Mechanism and ECB policies… ‘It’s not possible to say whether a ‘distortion’ in yield developments for sovereign bonds is due to fundamentally justified causes or whether there are potential exaggerations, irrationalities or other forms of inefficiencies… Higher refinancing costs for the private sector could also reflect higher national fiscal risks… That wouldn’t be a development for monetary policy to address, but rather a direct consequence of national fiscal policy.”
Draghi’s OMT (Outright Monetary Transactions) Plan has been heralded as “one of the most successful central bank operations in history”. After trading above 7.50% last summer, Spanish yields ended the week at 4.26%. Italian yields closed out the week at 4.05%, down from July 2012’s 6.50%. Since last summer, Spain’s economy and fiscal standing have deteriorated significantly. Italy’s economy has weakened and its political situation has become more unstable. Yet fundamentals have mattered little in the market for pricing Spanish and Italian debt, not with Draghi’s market backstop “bazooka” ready for action (and the Japanese apparently lined up to buy and the speculators lined up to front-run the Japanese).
It is widely expected that the German constitutional court will not rule against the ECB’s OMT. I have argued that Draghi’s market backstop altered European and global finance. Anytime the marketplace moves to place appropriate (based upon individual country fundamentals) risk premiums on troubled European borrowers, debt loads for the likes of Spain and Italy quickly turn unmanageable. The “Draghi Plan” placed the ECB’s balance sheet – open-ended purchases/“money printing” – as support underpinning troubled borrowers. Draghi acted despite strong opposition from German’s Bundesbank.
The Bundesbank has now detailed its objections in a 29 page document. Interestingly, the German central bank took exception to Draghi’s assurances that the ECB would guarantee the irreversibility of the euro. That’s not within a central bank’s mandate. The Bundesbank also questioned the credibility of the “conditionality” aspect of the OMT (troubled countries must agree to strict bailout terms before the ECB will purchase their bonds). The Germans noted that ECB liquidity assistance provided to Greek banks had been used to buy Greek government debt. “Monetary policy thus enabled the financing of a state by making liquidity available, although the conditions of a fiscal help program were not being met and fiscal policy had stopped the payment of further aid.” The German central bank also objected to the ECB purchasing risky debt at taxpayers’ expense, as well as the ECB’s loosening of collateral requirements.
I’ve always questioned the legitimacy of the ECB’s open-ended market backstop in the face of strong Bundesbank opposition. Yet with global QE liquidity abundantly available, the markets have felt no need to fret OMT issues. And, clearly, Japan’s recent incredible QE measures have further inflated European (and global) bond prices. I’ll assume the Japanese effect will have dissipated by the time of the German Constitutional Court ruling expected this summer. I’ll further presume that the issue of the OMT, the ECB, troubled European borrowers and reform backsliding will be front and center heading into this fall’s German elections. The Bundesbank is held in notably high regard by the German people.
April 25 - Dow Jones (Lingling Wei): “Chinese regulators are investigating certain bond-trading activities that could amplify risks in one of the world's fastest-growing debt markets, according to people with direct knowledge of the matter, after a recent slew of arrests of traders and other fixed-income personnel at Chinese financial institutions. The move, which follows recent regulatory actions aimed at cutting risks in China’s financial system, represents further evidence that Chinese authorities are taking seriously the country’s mounting debt load, especially funds raised outside of traditional banking channels…. The regulators are especially worried about trades used by banks or brokerage firms to move bonds off their balances sheets - which would move the bonds away from the scrutiny of regulators who are trying to limit the overall surge in domestic credit… China’s bond market, totaling more than 24 trillion yuan ($3.8 trillion) in debt outstanding, is the second largest in Asia after Japan.”
Moving along to another key Fault Line, there were further anecdotes this week supporting the view of unfolding Chinese financial fragility. The Shanghai Composite dropped 3.0% this week, with Chinese stocks notable nonparticipants in this week’s emerging market equities rally. Additional data confirmed economic sluggishness, while top government officials convened a special meeting to address economic issues.
April 26 – Bloomberg: “Borrowing costs for top-rated Chinese companies rose to a three-month high as the central bank’s probe into the $3.7 trillion interbank bond market drove investors into safer government securities. The People’s Bank of China asked market participants to examine trading histories as it cracks down on short-term transactions designed to bypass month-end risk evaluations… The investigation will force some investors to cut their bond investments as they can no longer ask others to hold the debt during regulatory reviews, according to Bank of America Merrill Lynch and Guotai Junan Securities Co. That may damp demand just as Premier Li Keqiang seeks to spur fundraising to revive the world’s second-biggest economy… ‘The bond market investigation is intensifying,’ Ethan Mou… strategist at Bank of America Merrill Lynch…said… ‘Many small banks, securities companies and funds are de-leveraging their credit holdings due to fear of exposure…’ ‘As growth slows, pressure on the government is building to loosen policy further,’ Zhang Zhiwei, Nomura’s chief China economist in Hong Kong, said… The Standing Committee’s comments show ‘the senior leadership has reached a consensus to tolerate slower growth’ and indicate that policy stimulus is unlikely, he said.”
I’m not about to run around the block shouting “the end of the financial system as we know it!” after Chinese corporate bond spreads widened to three-month highs. At the same time, talk of “de-leveraging” and heightened risk-aversion in China gets me keenly focused on Bubble analysis. My view holds that China is in the midst of a historic Credit Bubble with myriad unappreciated fragilities. I believe the Chinese government’s move to address asset Bubble risk coupled with efforts to more tightly regulate its fledgling (but gigantic!) bond markets and “shadow banking” system may mark a major Bubble inflection point.
Recall that cracks in subprime in the Spring of ’07 marked the beginning of the end of the great U.S. mortgage finance Bubble, although few at the time appreciated either the significance of subprime or systemic (financial and economic) fragilities. Actually, most at the time were quite dismissive of the view that subprime was even relevant.
Major Bubbles at some point inevitably turn susceptible to the marginal risky borrower losing access to cheap finance. Tightening might initially be imposed by the authorities or it could just be the marketplace beginning its eventual transition from greed to fear. And the larger the Bubble and the greater the excesses, the more high-risk borrowers and market distortions tend to dominate late-cycle (“terminal phase”) Credit expansion. The more protracted the Bubble, the more the entire system seems determined to push the risk envelope. And, best I can tell, in this regard risky Chinese Credit and attendant fragilities are at a grander scale than U.S. subprime.
I often ponder the nature of “subprime” lending, but this week I also found myself contemplating dynamics going back to the nineties “technology” Bubble. During that Bubble period, the media was absolutely infatuated with New Era and New Paradigm analysis. Technological innovation was making the economy more efficient and productive. And it was all right there in the data, indisputable, for all to see! Chairman Greenspan argued that the productivity revolution had fundamentally altered the inflation backdrop, allowing a higher “speed limit” for the U.S. economy. The Fed could err on the side of accommodating sound economic growth with low rates, with the tech revolution and economic paradigm shift justifying higher securities and asset prices. It doesn’t seem an inopportune time to be reminded that policy and conventional wisdom can be absolutely flawed. Especially when it comes to speculative markets, what is recognized as obvious can be susceptible to the less than obvious.
Greenspan and others disregarded key Bubble aspects. Sure, technology was improving efficiencies in the real economy. But integral to the so-called “productivity revolution” was actually an epic increase in capacity to manufacture technology products. And the longer over-liquefied and exuberant markets were allowed to run, the greater the degree of financial and economic distortion – the vast majority residing within the technology industry.
On the real economy side of the equation, virtually unlimited cheap finance spurred massive technology over-investment. On the financial side, huge speculative excess just accumulated- in stocks, bonds, derivatives and M&A. Importantly, the Fed’s Bubble accommodation proved highly destabilizing. When the equity and corporate debt Bubbles belatedly burst, rapid industry expansion abruptly reversed course and the true scope of boom-time excess began to surface.
So, what on earth could the tech Bubble have to do with the present? Well, the unimpressive performance of the “emerging markets” has been garnering a lot of attention. Commodities prices have been surprisingly weak in the face of massive global central bank quantitative easing measures. How could this be? The technology revolution thesis was undeniable; the investment opportunities obviously unprecedented. Global central bank policies have ensured an undeniable “global reflation” thesis; the investment opportunities have been seemingly unprecedented. Tech was a major Bubble. The emerging markets and the global “reflation trade”?
The longer the tech Bubble inflation was accommodated the more internal boom-time technology industry dynamics came to dominate – actually outweighing more generalized demand for technology products. The inundation of the industry with cheap finance ensured massive overinvestment, mal-investment and associated shenanigans. Basically, Bubble dynamics doomed the nineties tech boom. One might today contemplate to what extent Bubble dynamics have “doomed” the emerging markets.
Most analysts remain bullish. They note that developing central banks are sitting on treasure troves of international reserves, ensuring that these financial systems can readily manage the type of “hot money” outflows that proved catastrophic back in the nineties. Besides, with endless QE and a world awash in liquidity, there’s little reason to fret capital flight. It’s still commonly argued that the emerging economies have significantly more attractive debt profiles than many developed countries. And most extrapolate 7-8% Chinese growth as far as the eye can see. I suspect these views are too complacent.
Extremely loose financial conditions post the 2008 crisis fueled unprecedented emerging economy debt growth. I have highlighted the historic growth in Chinese Credit. While not on the same scale, major (and compounding) Credit expansions have transformed finance in Brazil, India, Russia, Eastern Europe and seemingly throughout the entire developing world universe. These economies have been on the receiving end of both unmatched direct investment and speculative flows.
As such, when it comes to “global reflation,” do the emerging markets remain an ongoing beneficiary? Or, have things quietly, but important, evolved? Did overheated “developing” Credit systems and economies evolve to the point of actually becoming the driving force behind global reflation? While global investors and speculators fixate on endless QE, would time be better spent these days focusing on domestic Credit systems throughout the “emerging” world? If so, then one must consider the possibility that “developing” Bubble fragility has been weighing on commodities prices. At the same time, a faltering commodities boom would work to tighten lending and financial conditions for the commodities players, while also tending to foster some isolated risk aversion and, perhaps, even less vigor for “risk on” overall. Has speculation, overinvestment, mal-investment and shenanigans associated with all things “global reflation” ensured a huge bust?
The accommodation associated with the Fed-orchestrated 1998 bailout of Long-Term Capital Management was instrumental in inciting “blow-off” technology Bubble excesses. It is my view that ongoing post-2008 crisis policy measures have fueled a protracted period of unprecedented excess throughout the emerging economies and Credit systems. I would posit that most “developing” financial systems and economic structures are particularly susceptible to prolonged boom-time maladjustment. At least on a historical basis, “emerging” Credit systems have demonstrated a proclivity for runaway inflations.
The conventional view holds that large reserve positions safeguard against destabilizing outflows. One could argue that this perception has only worked to entice unprecedented speculative inflows. Federal Reserve policies have instilled a market perception of endless dollar liquidity, dollar devaluation, and robust global reflationary forces. This backdrop has incited enormous dollar-denominated borrowings by governments, corporations and financial institutions throughout the emerging economies.
European economic weakness has increased “global reflation” and “developing” economy vulnerabilities. At the same time, the Draghi Plan and Fed open-ended QE stoked yet another bout of destabilizing global speculative excess. And it seems that Japan’s desperate QE measures have put the icing on the cake in terms of global perceptions of endless liquidity. Ironically, the belief that Japanese institutions and retail investors will shun “developing” debt in favor of “developed” has worked to the relative disadvantage of the emerging markets (in a world dominated by performance-chasing and trend-following speculation). Meanwhile, the Fed’s $85bn monthly QE has provided a competitive advantage to U.S. securities, especially beloved equities.
And as U.S. stocks outperform the world, a resurgent “King Dollar” dynamic supports dollar appreciation when seemingly the entire world has positioned for dollar devaluation. It seems as if a backdrop especially conducive to testing the “Reflation Trade” Bubble is materializing. As always, the timing of Bubble unwinds is fraught with great uncertainty.
April 26 – Financial Times (Michael Steen): “Germany’s Bundesbank has criticised the bond-buying programme designed by the European Central Bank to save the euro, questioning whether it is really necessary and suggesting it represents a great risk to taxpayers. Bundesbank president Jens Weidmann has been public from the outset in his institution’s opposition to the Outright Monetary Transactions programme launched in September by Mario Draghi, ECB president, after pledging to do ‘whatever it takes’ to save the euro. But revealed in an opinion written by the Bundesbank for the German constitutional court are a series of detailed objections to the plan…”
April 26 – Bloomberg (Jana Randow): “The Bundesbank criticized the European Central Bank’s bond-buying plan in an opinion for Germany’s Constitutional Court, saying diverging interest rates within the euro region aren’t necessarily something the ECB should fix. ‘Even though monetary policy is having different effects within the euro area, it is questionable whether these differences constitute a malfunctioning to be addressed by monetary policy,’ the Bundesbank wrote in an opinion… dated Dec. 21… Rising sovereign bond yields ‘cannot be used definitively as an explanation for a disturbance of monetary- policy transmission,’ the Bundesbank opinion says. Germany’s top court has scheduled hearings for June 11 and 12 to look into cases challenging the nation’s participation in the European Stability Mechanism and ECB policies… ‘It’s not possible to say whether a ‘distortion’ in yield developments for sovereign bonds is due to fundamentally justified causes or whether there are potential exaggerations, irrationalities or other forms of inefficiencies… Higher refinancing costs for the private sector could also reflect higher national fiscal risks… That wouldn’t be a development for monetary policy to address, but rather a direct consequence of national fiscal policy.”
Draghi’s OMT (Outright Monetary Transactions) Plan has been heralded as “one of the most successful central bank operations in history”. After trading above 7.50% last summer, Spanish yields ended the week at 4.26%. Italian yields closed out the week at 4.05%, down from July 2012’s 6.50%. Since last summer, Spain’s economy and fiscal standing have deteriorated significantly. Italy’s economy has weakened and its political situation has become more unstable. Yet fundamentals have mattered little in the market for pricing Spanish and Italian debt, not with Draghi’s market backstop “bazooka” ready for action (and the Japanese apparently lined up to buy and the speculators lined up to front-run the Japanese).
It is widely expected that the German constitutional court will not rule against the ECB’s OMT. I have argued that Draghi’s market backstop altered European and global finance. Anytime the marketplace moves to place appropriate (based upon individual country fundamentals) risk premiums on troubled European borrowers, debt loads for the likes of Spain and Italy quickly turn unmanageable. The “Draghi Plan” placed the ECB’s balance sheet – open-ended purchases/“money printing” – as support underpinning troubled borrowers. Draghi acted despite strong opposition from German’s Bundesbank.
The Bundesbank has now detailed its objections in a 29 page document. Interestingly, the German central bank took exception to Draghi’s assurances that the ECB would guarantee the irreversibility of the euro. That’s not within a central bank’s mandate. The Bundesbank also questioned the credibility of the “conditionality” aspect of the OMT (troubled countries must agree to strict bailout terms before the ECB will purchase their bonds). The Germans noted that ECB liquidity assistance provided to Greek banks had been used to buy Greek government debt. “Monetary policy thus enabled the financing of a state by making liquidity available, although the conditions of a fiscal help program were not being met and fiscal policy had stopped the payment of further aid.” The German central bank also objected to the ECB purchasing risky debt at taxpayers’ expense, as well as the ECB’s loosening of collateral requirements.
I’ve always questioned the legitimacy of the ECB’s open-ended market backstop in the face of strong Bundesbank opposition. Yet with global QE liquidity abundantly available, the markets have felt no need to fret OMT issues. And, clearly, Japan’s recent incredible QE measures have further inflated European (and global) bond prices. I’ll assume the Japanese effect will have dissipated by the time of the German Constitutional Court ruling expected this summer. I’ll further presume that the issue of the OMT, the ECB, troubled European borrowers and reform backsliding will be front and center heading into this fall’s German elections. The Bundesbank is held in notably high regard by the German people.
April 25 - Dow Jones (Lingling Wei): “Chinese regulators are investigating certain bond-trading activities that could amplify risks in one of the world's fastest-growing debt markets, according to people with direct knowledge of the matter, after a recent slew of arrests of traders and other fixed-income personnel at Chinese financial institutions. The move, which follows recent regulatory actions aimed at cutting risks in China’s financial system, represents further evidence that Chinese authorities are taking seriously the country’s mounting debt load, especially funds raised outside of traditional banking channels…. The regulators are especially worried about trades used by banks or brokerage firms to move bonds off their balances sheets - which would move the bonds away from the scrutiny of regulators who are trying to limit the overall surge in domestic credit… China’s bond market, totaling more than 24 trillion yuan ($3.8 trillion) in debt outstanding, is the second largest in Asia after Japan.”
Moving along to another key Fault Line, there were further anecdotes this week supporting the view of unfolding Chinese financial fragility. The Shanghai Composite dropped 3.0% this week, with Chinese stocks notable nonparticipants in this week’s emerging market equities rally. Additional data confirmed economic sluggishness, while top government officials convened a special meeting to address economic issues.
April 26 – Bloomberg: “Borrowing costs for top-rated Chinese companies rose to a three-month high as the central bank’s probe into the $3.7 trillion interbank bond market drove investors into safer government securities. The People’s Bank of China asked market participants to examine trading histories as it cracks down on short-term transactions designed to bypass month-end risk evaluations… The investigation will force some investors to cut their bond investments as they can no longer ask others to hold the debt during regulatory reviews, according to Bank of America Merrill Lynch and Guotai Junan Securities Co. That may damp demand just as Premier Li Keqiang seeks to spur fundraising to revive the world’s second-biggest economy… ‘The bond market investigation is intensifying,’ Ethan Mou… strategist at Bank of America Merrill Lynch…said… ‘Many small banks, securities companies and funds are de-leveraging their credit holdings due to fear of exposure…’ ‘As growth slows, pressure on the government is building to loosen policy further,’ Zhang Zhiwei, Nomura’s chief China economist in Hong Kong, said… The Standing Committee’s comments show ‘the senior leadership has reached a consensus to tolerate slower growth’ and indicate that policy stimulus is unlikely, he said.”
I’m not about to run around the block shouting “the end of the financial system as we know it!” after Chinese corporate bond spreads widened to three-month highs. At the same time, talk of “de-leveraging” and heightened risk-aversion in China gets me keenly focused on Bubble analysis. My view holds that China is in the midst of a historic Credit Bubble with myriad unappreciated fragilities. I believe the Chinese government’s move to address asset Bubble risk coupled with efforts to more tightly regulate its fledgling (but gigantic!) bond markets and “shadow banking” system may mark a major Bubble inflection point.
Recall that cracks in subprime in the Spring of ’07 marked the beginning of the end of the great U.S. mortgage finance Bubble, although few at the time appreciated either the significance of subprime or systemic (financial and economic) fragilities. Actually, most at the time were quite dismissive of the view that subprime was even relevant.
Major Bubbles at some point inevitably turn susceptible to the marginal risky borrower losing access to cheap finance. Tightening might initially be imposed by the authorities or it could just be the marketplace beginning its eventual transition from greed to fear. And the larger the Bubble and the greater the excesses, the more high-risk borrowers and market distortions tend to dominate late-cycle (“terminal phase”) Credit expansion. The more protracted the Bubble, the more the entire system seems determined to push the risk envelope. And, best I can tell, in this regard risky Chinese Credit and attendant fragilities are at a grander scale than U.S. subprime.
I often ponder the nature of “subprime” lending, but this week I also found myself contemplating dynamics going back to the nineties “technology” Bubble. During that Bubble period, the media was absolutely infatuated with New Era and New Paradigm analysis. Technological innovation was making the economy more efficient and productive. And it was all right there in the data, indisputable, for all to see! Chairman Greenspan argued that the productivity revolution had fundamentally altered the inflation backdrop, allowing a higher “speed limit” for the U.S. economy. The Fed could err on the side of accommodating sound economic growth with low rates, with the tech revolution and economic paradigm shift justifying higher securities and asset prices. It doesn’t seem an inopportune time to be reminded that policy and conventional wisdom can be absolutely flawed. Especially when it comes to speculative markets, what is recognized as obvious can be susceptible to the less than obvious.
Greenspan and others disregarded key Bubble aspects. Sure, technology was improving efficiencies in the real economy. But integral to the so-called “productivity revolution” was actually an epic increase in capacity to manufacture technology products. And the longer over-liquefied and exuberant markets were allowed to run, the greater the degree of financial and economic distortion – the vast majority residing within the technology industry.
On the real economy side of the equation, virtually unlimited cheap finance spurred massive technology over-investment. On the financial side, huge speculative excess just accumulated- in stocks, bonds, derivatives and M&A. Importantly, the Fed’s Bubble accommodation proved highly destabilizing. When the equity and corporate debt Bubbles belatedly burst, rapid industry expansion abruptly reversed course and the true scope of boom-time excess began to surface.
So, what on earth could the tech Bubble have to do with the present? Well, the unimpressive performance of the “emerging markets” has been garnering a lot of attention. Commodities prices have been surprisingly weak in the face of massive global central bank quantitative easing measures. How could this be? The technology revolution thesis was undeniable; the investment opportunities obviously unprecedented. Global central bank policies have ensured an undeniable “global reflation” thesis; the investment opportunities have been seemingly unprecedented. Tech was a major Bubble. The emerging markets and the global “reflation trade”?
The longer the tech Bubble inflation was accommodated the more internal boom-time technology industry dynamics came to dominate – actually outweighing more generalized demand for technology products. The inundation of the industry with cheap finance ensured massive overinvestment, mal-investment and associated shenanigans. Basically, Bubble dynamics doomed the nineties tech boom. One might today contemplate to what extent Bubble dynamics have “doomed” the emerging markets.
Most analysts remain bullish. They note that developing central banks are sitting on treasure troves of international reserves, ensuring that these financial systems can readily manage the type of “hot money” outflows that proved catastrophic back in the nineties. Besides, with endless QE and a world awash in liquidity, there’s little reason to fret capital flight. It’s still commonly argued that the emerging economies have significantly more attractive debt profiles than many developed countries. And most extrapolate 7-8% Chinese growth as far as the eye can see. I suspect these views are too complacent.
Extremely loose financial conditions post the 2008 crisis fueled unprecedented emerging economy debt growth. I have highlighted the historic growth in Chinese Credit. While not on the same scale, major (and compounding) Credit expansions have transformed finance in Brazil, India, Russia, Eastern Europe and seemingly throughout the entire developing world universe. These economies have been on the receiving end of both unmatched direct investment and speculative flows.
As such, when it comes to “global reflation,” do the emerging markets remain an ongoing beneficiary? Or, have things quietly, but important, evolved? Did overheated “developing” Credit systems and economies evolve to the point of actually becoming the driving force behind global reflation? While global investors and speculators fixate on endless QE, would time be better spent these days focusing on domestic Credit systems throughout the “emerging” world? If so, then one must consider the possibility that “developing” Bubble fragility has been weighing on commodities prices. At the same time, a faltering commodities boom would work to tighten lending and financial conditions for the commodities players, while also tending to foster some isolated risk aversion and, perhaps, even less vigor for “risk on” overall. Has speculation, overinvestment, mal-investment and shenanigans associated with all things “global reflation” ensured a huge bust?
The accommodation associated with the Fed-orchestrated 1998 bailout of Long-Term Capital Management was instrumental in inciting “blow-off” technology Bubble excesses. It is my view that ongoing post-2008 crisis policy measures have fueled a protracted period of unprecedented excess throughout the emerging economies and Credit systems. I would posit that most “developing” financial systems and economic structures are particularly susceptible to prolonged boom-time maladjustment. At least on a historical basis, “emerging” Credit systems have demonstrated a proclivity for runaway inflations.
The conventional view holds that large reserve positions safeguard against destabilizing outflows. One could argue that this perception has only worked to entice unprecedented speculative inflows. Federal Reserve policies have instilled a market perception of endless dollar liquidity, dollar devaluation, and robust global reflationary forces. This backdrop has incited enormous dollar-denominated borrowings by governments, corporations and financial institutions throughout the emerging economies.
European economic weakness has increased “global reflation” and “developing” economy vulnerabilities. At the same time, the Draghi Plan and Fed open-ended QE stoked yet another bout of destabilizing global speculative excess. And it seems that Japan’s desperate QE measures have put the icing on the cake in terms of global perceptions of endless liquidity. Ironically, the belief that Japanese institutions and retail investors will shun “developing” debt in favor of “developed” has worked to the relative disadvantage of the emerging markets (in a world dominated by performance-chasing and trend-following speculation). Meanwhile, the Fed’s $85bn monthly QE has provided a competitive advantage to U.S. securities, especially beloved equities.
And as U.S. stocks outperform the world, a resurgent “King Dollar” dynamic supports dollar appreciation when seemingly the entire world has positioned for dollar devaluation. It seems as if a backdrop especially conducive to testing the “Reflation Trade” Bubble is materializing. As always, the timing of Bubble unwinds is fraught with great uncertainty.
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