Bill Gross Explains How To Escape A Sinking Ship
It is unclear if the florid analogy in Bill Gross' latest monthly letter, namely a "sinking ship" or at least a seaborne vessel on the verge of being one, is supposed to represent the US economy, the bond market, or the Fed, but whatever it is, Bill, who is in the business of making money when bonds go up and vice versa and who nearly sank a ship while a naval officer, appears confident no ship is sinking. Yet. "The U.S. economy is not sinking, nor are the majority of global economies. Their markets just had too much risk, and in PIMCO’s opinion, too much hope for a constant QE and for the growth that it would produce. In effect, the ship was top heavy with too little ballast."
Sure it is, but while it inspired many a monthly letter bashing the Fed's ruinous policies not for Gross but for the 99%, it led to a record Total Return Fund AUM and record fees. What Bill is more confused, and even angry by, by is the dramatic bear flattening in the bond curve which was the most dramatic move in the past few weeks: not so much the move in equities, not the shift in credit spreads, not the vol in FX. Why is he surprised: because not even he had any idea to what extent everyone else was also frontrunning the Fed on a very levered basis. Which is why the TSY curve belly exploded as it did, wiping out billions in P&L from Gross and many comparable bond managers. Next comes the raging into the void by PMs who did not foresee precisely what they were warning about...
As for the economy, or bond market, or whatever, maybe not sinking, but certainly taking on water as Bill admits when he tell Bernanke's "cyclically oriented Fed" that "structural headwinds – demographic, globalization, and technology influences – that have had and will continue to have dampening effects on domestic and global growth."
However, what is lost on Bill is that as we explained yesterday, the Fed is far more concerned with collateral extraction as per the TBAC. Which means the upcoming Tapering episode will come, but following yet another very violent market reaction (has anyone seen what is going on in MBS ? ), it will immediately unleash the UNtaper, and even more QE, and with it wipe out any pretense that eligible "quality" collateral (or lack thereof) matters when the S&P goes back into triple digit territory.
Because if the merest hint of just a slowdown in monetization leads to this... "Without the presence of a “Bernanke Put” or the promise of a continuing program of QE check writing, investors found the lifeboats dysfunctional. They could only sell to themselves and almost all of them had too much risk. A band somewhere on the upper deck began to play“Nearer, My God, to Thee.”... Imagine what would happen in 2014 or 2015 when the market suddenly finds itself facing a grim cravasse in which some 1000 S&P Fed-injected points are about to be "priced-out."
That said, while Gross' piece brings up many questions, it certainly answers one: on whose side the Newport Beach bond manager is: "PIMCO, and the bond market have sailed some rough seas over the past few years. So has Chairman Bernanke. We’re all in thisi one together it seems."
Well, if one excludes some 99% of America's, and the world's, population Gross is absolutely correct...
* * *
From PIMCO's Bill Gross:
July Outlook: The Tipping Point
I’ve spun a few yarns in recent years about my days as a naval officer; not, thank goodness, tales told by dead men, but certainly echoes from the depths of Davy Jones’ Locker. A few years ago I wrote about the time that our ship (on my watch) was almost cut in half by an auto-piloted tanker at midnight, but never have I divulged the day that the USS Diachenko came within one degree of heeling over during a typhoon in the South China Sea. “Engage emergency ballast,” the Captain roared at yours truly – the one and only chief engineer. Little did he know that Ensign Gross had slept through his classes at Philadelphia’s damage control school and had no idea what he was talking about. I could hardly find the oil dipstick on my car back in San Diego, let alone conceive of emergency ballast procedures in 50 foot seas. And so…the ship rolled to starboard, the ship rolled to port, the ship heeled at the extreme to 36 degrees (within 1 degree, as I later read in the ship’s manual, of the ultimate tipping point). One hundred sailors at risk, because of one twenty-three-year-old mechanically challenged officer, and a Captain who should have known better than to trust him.
We survived, and a year later I exited – the Diachenko and the Navy for good – theirs and mine. I think I heard a sigh of relief as I saluted the Captain for the last time, but in memory of those nearly tragic moments, let me reprint an article posted on wikiHow, outlining exactly how to go about abandoning ship should you ever venture into the South China Sea or anywhere close to Davy’s infamous locker. The article is a bona fide and serious attempt to instruct would be passengers in a Titanic-like disaster. I found it, however, as comical as yours truly pretending to be a chief engineer in 1969. Judge for yourself…
wikiHow: the how to manual you can edit
The Basics: Before Setting Sail
1. Understand the mechanics of a sinking ship. Water usually enters the lowest point of a ship first, the bilge area.
2. As more and more water enters the ship, it will start to heel significantly. From this point on, sinking will occur quickly. Abandon ship.
If Sinking is Imminent
1. Think about your sense of etiquette. What will you do if push comes to shove?
2. If you’re in charge of the sinking ship learn how to send a Mayday. Read “How to call Mayday from a marine vessel” on the attached internet link.
3. Stay calm and don’t panic.
4. If you see someone with fear, yell at them.
5. While still on deck, watch for catapulting objects coming your way. Large items can kill you.
Abandoning Ship
6. Find a lifeboat. The best scenario is to enter a lifeboat without getting wet.
7. If jumping off the ship, always look first.
8. If you survive, be ready for the reality that others may have perished. Seek counseling.
Counseling indeed! If only I knew then what I know now: wikiHow, not experience or damage control school, is the best teacher. So, should bond investors abandon ship? And who to believe? The captain of the Fed, the co-captains of the USS PIMCO, or just trust your instincts? Well there is no wikiHow moment to guide you in this case, although it’s true that yours truly, PIMCO, and the bond market have sailed some rough seas over the past few years. So has Chairman Bernanke. We’re all in this one together it seems.
Immediate analysis of the past 6 weeks’ market action would argue that in late April, both the Fed and PIMCO observed that bond markets were approaching a tipping point.Yields were too low, prices too high, both for investors’ and the economy’s own good. The Fed’s Jeremy Stein had written a research paper outlining the risk. I, in fact, had written a MarchInvestment Outlook outlining Governor Stein’s paper, and to be fair, PIMCO had been warning of high seas for what seems like an eternity. “Never,” I tweeted, “have investors reached so high for so little return. Never have investors stooped so low for so much risk.” True enough, history will likely record.
It will also record however, that the risk was not only in narrow credit spreads and emerging market debt/equity markets but at the heart of the credit system itself: U.S. Treasuries. What supposedly old salts like yours truly didn’t suspect was that all bonds, and yes, equities too were at risk of heeling over based upon a rather perfect storm, one that forecasters everywhere found difficult to fathom.
The forecast for bad weather as I’ve mentioned was becoming more rational with every increase in asset prices. If all markets were being artificially supported as PIMCO claimed and the Fed confirmed, then someday, someday that support via quantitative easing would have to be withdrawn. But the dark clouds seemed to be far off on the horizon. Investors worldwide piled on the leverage – not just in high yield or equity space – but in Treasuries as well. If the Fed (and BOJ) were going to keep writing checks at one trillion per year, then these two central banks alone might be buying 70-80% of all developed market future supply. The fear was that there might not be enough for others, not that there was too much leverage.
Well, that started to change with the May 22ndtaper talk and, of course, with the Fed’s June 19th statement and Chairman Bernanke’s press conference. In trying to be specific about which conditions would prompt a tapering of QE, the Fed tilted overrisked investors to one side of an overloaded and overlevered boat. Everyone was looking for lifeboats on the starboard side of the ship, and selling begat more selling, even in Treasuries. While the Fed’s move may ultimately be better understood or even praised, it no doubt induced market panic. Without the presence of a “Bernanke Put” or the promise of a continuing program of QE check writing, investors found the lifeboats dysfunctional. They could only sell to themselves and almost all of them had too much risk. A band somewhere on the upper deck began to play“Nearer, My God, to Thee.”
Well I go too far in my sinking ship metaphor, but you get the point, I hope. The U.S. economy is not sinking, nor are the majority of global economies. Their markets just had too much risk, and in PIMCO’s opinion, too much hope for a constant QE and for the growth that it would produce. In effect, the ship was top heavy with too little ballast. Guess I should have known, huh?
Well where does the ship go from here? Should you as a bond investor jump overboard and risk the cold money market Atlantic Ocean at near zero degrees? We don’t think so – and not because we want to keep you on board – we just don’t think so. Why not?
1) The Fed’s forecast of the economy which prompted tapering panic is far too optimistic. If 7% unemployment is tapering’s final port of call, we simply think that we’re much further away than the Fed’s compass would suggest. We argue for structural headwinds – demographic, globalization, and technology influences – that have had and will continue to have dampening effects on domestic and global growth. The Fed, we would argue, is too cyclically oriented, focusing substantially on housing prices and car sales. And speaking of housing, since mortgage rates have risen by 1½% in the last six months and the average monthly check for a new home buyer is up by 20–25% as well, then as I tweeted several weeks ago, “Mr. Chairman are you serious?” Growth will be negatively influenced.
2) Inflation, according to the Fed’s own statistics is running close to a 1% pace. The Fed has told us that they “target,” “ target” 2% and for the next 1–2 years are willing to accept even 2½% until they reverse engines. Fed Governor Bullard of the St. Louis Fed was in our opinion correct where he dissented from the majority decision several weeks ago, citing the distant shores of 2%+ inflation and the seeming inability to even move in that direction.
3) Yields have adjusted by too much. While T.V. and the press focus on 10-year Treasuries at 2.55% as their guiding star, subjective stabs by yours truly or anyone else are difficult day to day. The technicals, as Mohamed has written, can dominate while the fundamentals are flushed to second page priorities. When analyzing the fundamentals though, I like to point to a “North Star” that is as permanent as possible within the context of current market instability. Tapering aside, if the Fed has consistently informed the market that its policy rate – Fed Funds at 25 basis points – will stay there for a substantial period of time even after the end of QE, then to my eye, Fed Funds will not increase until at least mid-2015 and even then subject to a consistently strong economy that produces 2%+ inflation. I wonder if we can get there in this decade to tell you the truth. But the beauty of this North Star Fed Funds sextant is that it can be rather directly observed in futures markets, either for Fed Funds or for Eurodollars, which are a close companion. Right now, Fed Funds futures markets are predicting a 75 basis point yield in 2015, and Eurodollars validating a similar conclusion. That would suggest a mispricing, despite the obvious caveat of professional observers that some of the 75 is a surcharge for potential volatility. In any case, if frontend curves are up to 50 basis points cheap, then intermediate curves – the 10-year Treasury – may be as much as 35 basis points too cheap. They belong in our opinion at 2.20% instead of 2.55%.
So there you have it, fellow passengers and paying clients. Don’t jump ship now. We may have reached an inflection point of low Treasury, mortgage and corporate yields in late April, but this is overdone. Will there be smooth sailing tomorrow? “Red sky at night, sailors delight?” Hardly. Will you be able to replicate annualized returns in bonds and stocks for the past 20–30 years? Hardly. Expect 3–5% for both. But sailors, don’t panic. And like wikiHow suggests, if you see someone that’s afraid, “yell at them!” Yell, “This ship’s going to make it to port,” Fed, PIMCO, and PIMCO co-captains willing. Those icy Atlantic money market waters are likely to be with us for a long, long time. Have a cocktail, tell the band to stop playing dirges, because you’re gonna be just fine with PIMCO at the helm.
Uninsurable Risks
June 28, 2013
An extraordinarily unsettled quarter ends on a tenuous up note.
June 24 – Financial Times (Alistair Gray and Pilita Clark): “Insurers have issued a rare warning that the speed at which the oceans are warming is threatening their ability to sell affordable policies in a growing number of places around the world. Parts of the UK and the US state of Florida were already facing ‘a risk environment that is uninsurable’, said the global insurance industry trade body, the Geneva Association. They were unlikely to be the last areas with such problems, said John Fitzpatrick, the association’s secretary-general… ‘Governments may have fiscal austerity issues in the short run. But in the long run they’re going to have big exposures – to repair damaged infrastructure from storms.’ …In spite of the losses from Sandy and a spate of natural catastrophes the previous year, overall global property insurance premiums have remained broadly stable outside loss-hit areas. However, insurers warn premiums have been kept artificially depressed in the short term because capital has flocked to the sector in the face of historic low interest rates.”
I found multiple reasons this week to think back to a March 2000 CBB, “A Derivative Story.” It was my fictional account of how cheap flood insurance spurred a spectacular boom and bust cycle on “a little town along the river”.
Basically, writing flood insurance during a drought provided extraordinary “return” opportunities. A speculative Bubble developed in the marketplace, whereby thinly capitalized speculators came to dominate the market for cheap insurance. The easy availability of inexpensive protection was instrumental in fueling a self-reinforcing economic Bubble along the waterfront. Between the building boom and inflating real estate prices, the amount of outstanding flood insurance ballooned (exponentially). As speculation in this marketplace turned manic, the entire insurance “industry” became precariously undercapitalized, especially in the context of rapidly inflating latent risks. Losses had been avoided for years – and many just presumed drought was the new normal. And in the unexpected event of torrential rainfall, most anticipated “hedging” potential flood loss exposures in the liquid marketplace for cheap reinsurance. Well, the insurance market collapsed in illiquidity with the inevitable arrival of a major flood. Financial and economic losses proved catastrophic in my sad little tale.
So have the Bernanke Federal Reserve and fellow global central banks been adeptly supporting the global economic recovery after 2008’s “hundred year flood” - as conventional thinking believes? Or have they instead been inflating history’s greatest Credit Bubble? Policy uncertainties and unstable global markets have again made this a pressing question.
The usual (“inflationist”) punditry has been in attack mode against Bernanke’s call to begin (most gingerly) the process of backing away from extraordinary crisis-period quantitative easing measures. They claim the recovery remains too weak and inflation too low to contemplate policy “tightening.” Some go so far as to claim the Fed is repeating its 1937 mistake, whereby tightening measures are said to have aborted a fledgling recovery and needlessly extended the Great Depression.
Every boom and bust cycle runs its own course. But I would strongly argue any comparison to 1937 is misguided. In no way do I believe the 2008 financial crisis was the current historic cycle’s 1929. There was indeed significant financial and economic stress in 2008/09. But there was definitely no global collapse in Credit or economic activity – no globalized economic depression. Actually, on a global basis debt growth has run unabated. And after a meaningful yet non-catastrophic setback in 2009, global GDP growth quickly recovered. With record outstanding debt, record GDP and near-record securities prices, it’s unreasonable to argue for unending depression-era fiscal and monetary stimulus.
More than a decade ago, Dr. Bernanke, with his “helicopter money” and “government printing press,” arrived on the scene with academic theories to fight the scourge of deflation. Well, the tech Bubble had burst - but I argued strongly at the time that THE greater Credit Bubble was very much alive and well. Extraordinary Fed stimulus was poised to inflate the fledgling mortgage finance Bubble. I argued in 2009 that THE Bubble hadn’t burst, instead unmatched global fiscal and monetary stimulus had unleashed the “granddaddy of them all” – the global government finance Bubble.
This is not “intelligentsia” – and I would add that recent market developments have again made this a most pertinent “debate.” Has the Fed been successfully countering a post-Bubble landscape - or has it instead been further inflating a historic Bubble? Do Dr. Bernanke’s academic theories of how the Fed must ensure there is ample “money” in the real economy to address insufficient demand really hold water? Or have zero rates and Trillions of QE simply flooded excess liquidity into already distorted global securities markets? Has Federal Reserve policy led to runaway Bubbles in dysfunctional risk markets – fueling an epic global “building boom along the river”?
I have in past CBBs noted key differences between the traditional government currency printing press and today’s newfangled electronic version. Traditional monetary inflations created government currency - purchasing power that worked to bid up prices throughout the real economy. The contemporary “printing press” creates electronic debit and credit entries that predominantly provide new purchasing power that bids up prices of financial assets. I have argued that this mechanism has been fueling dangerous securities markets and asset Bubbles around the globe. I have further argued that the Fed and central banks had unwittingly nurtured acute Bubble fragility to any potential reduction in central bank liquidity.
How does one reconcile massive ongoing “money printing” with deflating commodities prices and generally contained consumer price inflation? Well, perhaps the commodities market is the proverbial “canary in the coalmine” warning that QE has indeed fueled increasingly vulnerable Credit and asset Bubbles. The backdrop is increasingly reminiscent of the late-1920s, when many (including the Fed) believed weak commodity prices were a call for further monetary accommodation. I am today playing the role of the “old codgers” from the Roaring Twenties that warned of the dangers (and utter futility) of trying to sustain a deeply maladjusted system and historic financial Bubbles. While they were correct in their analysis, history has been unkind to these “liquidationists” and Bernanke “Bubble poppers.” Dr. Bernanke (and conventional thinking) is convinced the issue during the late-twenties and thirties was deflation and the Fed’s negligence in failing to print sufficient money supply. I am convinced that Bernanke’s analysis is flawed: the key issue was the Fed repeatedly placed “coins in the fusebox” during the twenties – in the process accommodating precarious financial and economic Bubbles.
Quantifying current Bubble risk is an impossible task. Global debt and securities markets easily surpass a hundred Trillion. Gross derivative exposures are in the many hundreds of Trillions. The now enormous Chinese and EM financials systems, in particular, lack transparency. The amount of global speculative leverage is unknown. The degree of global financial distortion and economic maladjustment will not become apparent until the next major period of market risk aversion and resulting tightened global financial conditions. For now, recent market gyrations support my view of precarious Latent Market Bubble Risks.
I’ll attempt to use some data to illustrate how Fed policymaking has greatly exacerbated already outsized market risks. As a crude proxy for “market risk,” I’ll combine outstanding Treasury debt, Agency debt/MBS, Corporate bonds, municipal debt and the value of U.S. equities – securities that fluctuate in the marketplace based upon perceptions of value, liquidity and risk. It is worth noting that “market risk” had inflated to $33 TN during the booming nineties, after beginning the decade at $10 TN. Importantly, the nineties saw a fundamental shift to market-based Credit instruments, with the proliferation of ABS, MBS, the GSEs and “Wall Street Finance” more generally.
I have over the years argued that Credit is inherently unstable. The move to market-based debt instruments created an acutely unstable Credit system, instability that provoked a change at the Federal Reserve to a policy regime committed to backstopping the securities markets. For more than twenty years now, this new policy regime has led to an unending series of Bubbles, booms and busts, even more aggressive policy responses and only bigger, more precarious Bubbles. This is critical analysis that remains completely outside of mainstream economic thinking.
When Dr. Bernanke began his crusade against deflation risk back in 2002, “market risk” was at $29.7 TN. Extraordinary monetary stimulus (and resulting mortgage finance Bubble excess) was instrumental in market risk surging to $53 TN by the end of 2007, before dropping abruptly to $44.8 TN in 2008. During the past four years, “market risk” has inflated $16.7 TN, or 37%, to a record $61.5 TN. Perhaps more illuminating, as a percentage of GDP, “market risk” began the 1990’s at 182% and closed the decade at 323%. Post tech-Bubble asset prices had the ratio back to 284% by the end of 2002. By 2007, however, it had inflated all the way to 378%. In 2009 it fell back to 314%. It then ended 2012 at a record 392%. From another angle, over the past 10 years GDP increased $5.2 TN, or 50%, while “market risk” inflated $31.8 TN, or 107%. While conventional thinking subscribes to the post-2008 deleveraging viewpoint, I believe the data strongly support my re-leveraging and historic Bubble thesis.
Global insurance companies have come to believe that global climate change has made some locations “Uninsurable.” Extraordinary changes in the weather landscape have made areas so prone to potential catastrophe that risks cannot be effectively priced in the insurance market and reserved for by those writing policies.
I will posit that years of central bank intrusion and market domination have made global risk markets “Uninsurable.” “Market risk” has ballooned precariously higher, with massive issuance of non-productive government debt and other late-cycle private-sector Credit excesses. Meanwhile, central bank liquidity injections have inflated global asset market prices, while inciting speculation along with a manic global search for yield. Distorted "Bubble" global economies are increasingly succumbing to the debt and maladjustment overhang, while Financial Euphoria has seen securities markets inflate into dangerous speculative Bubbles.
There is a great flaw in the Bernanke doctrine of inflating the Fed’s balance sheet to both accommodate massive fiscal deficits and inflate securities markets, while using zero rates to force savers into the risk markets. This has led to an unprecedented (and problematic) mispricing of debt and securities prices globally, while incentivizing leveraging and speculation. Trillions of risk-conscious “money” has flowed into global markets (through ETFs, hedge funds, mutual funds, etc.) with little appreciation for the true risk-profile of global financial markets. One could say a Bubble in perceived low-risk “investing” evolved into a key facet of the overall global risk market Bubble.
There remains a perception that risks can be readily hedged and that central banks will ensure liquid markets even in the event that the marketplace moves to de-risk. But the marketplace cannot offload market risk. Risks can be shifted around the marketplace. Yet if the market en masse seeks to reduce risk there is no one with the wherewithal to take the other side of the trade. This issue becomes especially salient when market risks are exceptionally elevated; when risks are underappreciated and misunderstood; and when most (sophisticated speculators, investors and unsophisticated “savers” alike) are heavily committed to the risk markets. That’s where I believe we are today.
Importantly, at least segments of the “global leveraged speculating community” must by now be increasingly impaired. The gold, precious metals and commodities “reflation trade” has been an unmitigated disaster. While not yet a full-fledged disaster, the popular emerging market (EM) trade is unraveling. The currencies and global leveraged “carry trades” have become perilous minefields. Global fixed income markets, more generally, are increasingly unstable and illiquid.
Extremely low market yields and risk premiums/Credit spreads ensured the speculators ramped up leverage in order to achieve their bogey 8-9% (pension fund acceptable) annual returns. The exchange-traded fund (ETF) phenomenon ensured that a couple Trillion flowed easily into all types of mispriced asset classes. The torrent of leveraged buying and ETF flows brought unprecedented liquidity to generally illiquid U.S. corporate and municipal bonds. A torrent of leveraged buying and ETF flows brought unprecedented liquidity to EM markets that over the years earned their “roach motels” moniker. A torrent of flows ensured ultra-easy financial conditions that for four years have worked to validate the (mis)perception of minimal risk throughout U.S. and global markets.
Of course, New York President Dudley and other Fed officials have come out to comfort an unsettled marketplace. Dudley even suggested that the Fed could actually do QE bigger and longer if necessary. Such pandering is precisely why markets are these days so exposed to Bubble risks. The Fed has made such an incredible mess of monetary policy. Fed policies have fomented a historic Bubble and there will no painless extrication. Various Fed officials have said the market has “misinterpreted,” “misunderstood,” and is “quite out of synch” with the Fed’s recent policy message. I don’t believe the market misunderstands the Fed as much as the Fed and market participants for years have misunderstood market risk dynamics.
Bubbles don’t inflate forever. I’ll assume that at least the sophisticated market operators now appreciate the rapidly escalating risk to EM markets and economies. I’ll assume there is newfound appreciation for the serious liquidity issues overhanging various markets. I’ll assume the leveraged players are responding to the new backdrop with plans for reduced leverage and risk. The sophisticated market operators will now work to “distribute” risk to the less sophisticated, a process they expect will be aided by ongoing Fed verbal and QE market support.
Prominent fund managers and bullish pundits have blanketed the airways the past few days with hopeful messages that the worst of the bond selling is over and that the great equities bull market remains intact. It’s just not going to be that easy. Outflows from bond, EM and stock funds have been enormous. Despite this week’s rally, the fear is that investors will be none too pleased when they see monthly/quarterly brokerage statements. The “sophisticated” surely don’t want to be in a situation where they’re fighting the “unsophisticated” to the exits. They need to see that feel-good bull market feeling return to risk markets relatively quickly - or else.
Above I mentioned how Federal Reserve doctrine changed during the nineties to support the proliferation of market-based Credit. During the decade, the market for derivatives and myriad types of risk insurance ballooned right along with Credit and market risk. I’ve argued over the years that Credit and financial market risk are actually Uninsurable – in that they are neither random nor independent events such as car accidents and house fires. Actually, it is the nature of market risk for losses to occur in particularly non-random and non-independent waves. Somehow the lessons of 2008 were quickly unlearned.
And while I’m on the subject of risk management, it’s worth noting that for years one could simply mitigate risk by holding Treasuries (and bunds, agency debt, etc.). In the event of market turbulence, rising Treasury prices would work to offset declining prices for stocks, junk bonds and such. Problematically, Treasury prices have of late been declining right along with risk assets, as “safe haven”, risk asset and commodity prices all turn atypically correlated. There’s been a proliferation of “risk parity” strategies that are struggling under current market conditions. If things don’t normalize quickly, market participants will be forced to adjust their views of risk and liquidity management.
In a way, the Federal Reserve has for years circumvented “nature” by assuring market liquidity. It is this assurance that has empowered a booming derivatives “insurance” marketplace that operates on the specious assumption of “liquid and continuous markets.” The vast majority of derivative market insurance written requires some degree of “dynamic” hedging – i.e. selling of instruments to generate sufficient cash flow to pay on market insurance contracts sold/written. This is one of those key Latent Market Bubble Risks.
Global climate change is fundamentally altering the risk and the insurance marketplace, although “premiums have been kept artificially depressed in the short term because capital has flocked to the sector in the face of historic low interest rates.” Global central banks have unwittingly inflated risk and grossly distorted the risk “insurance” landscape across global risk markets. We’ll see how long “capital” continues to flock to global securities markets. Early indications of how global risk markets will function in the face of a reversal of flows are anything but encouraging.
June 24 – Financial Times (Alistair Gray and Pilita Clark): “Insurers have issued a rare warning that the speed at which the oceans are warming is threatening their ability to sell affordable policies in a growing number of places around the world. Parts of the UK and the US state of Florida were already facing ‘a risk environment that is uninsurable’, said the global insurance industry trade body, the Geneva Association. They were unlikely to be the last areas with such problems, said John Fitzpatrick, the association’s secretary-general… ‘Governments may have fiscal austerity issues in the short run. But in the long run they’re going to have big exposures – to repair damaged infrastructure from storms.’ …In spite of the losses from Sandy and a spate of natural catastrophes the previous year, overall global property insurance premiums have remained broadly stable outside loss-hit areas. However, insurers warn premiums have been kept artificially depressed in the short term because capital has flocked to the sector in the face of historic low interest rates.”
I found multiple reasons this week to think back to a March 2000 CBB, “A Derivative Story.” It was my fictional account of how cheap flood insurance spurred a spectacular boom and bust cycle on “a little town along the river”.
Basically, writing flood insurance during a drought provided extraordinary “return” opportunities. A speculative Bubble developed in the marketplace, whereby thinly capitalized speculators came to dominate the market for cheap insurance. The easy availability of inexpensive protection was instrumental in fueling a self-reinforcing economic Bubble along the waterfront. Between the building boom and inflating real estate prices, the amount of outstanding flood insurance ballooned (exponentially). As speculation in this marketplace turned manic, the entire insurance “industry” became precariously undercapitalized, especially in the context of rapidly inflating latent risks. Losses had been avoided for years – and many just presumed drought was the new normal. And in the unexpected event of torrential rainfall, most anticipated “hedging” potential flood loss exposures in the liquid marketplace for cheap reinsurance. Well, the insurance market collapsed in illiquidity with the inevitable arrival of a major flood. Financial and economic losses proved catastrophic in my sad little tale.
So have the Bernanke Federal Reserve and fellow global central banks been adeptly supporting the global economic recovery after 2008’s “hundred year flood” - as conventional thinking believes? Or have they instead been inflating history’s greatest Credit Bubble? Policy uncertainties and unstable global markets have again made this a pressing question.
The usual (“inflationist”) punditry has been in attack mode against Bernanke’s call to begin (most gingerly) the process of backing away from extraordinary crisis-period quantitative easing measures. They claim the recovery remains too weak and inflation too low to contemplate policy “tightening.” Some go so far as to claim the Fed is repeating its 1937 mistake, whereby tightening measures are said to have aborted a fledgling recovery and needlessly extended the Great Depression.
Every boom and bust cycle runs its own course. But I would strongly argue any comparison to 1937 is misguided. In no way do I believe the 2008 financial crisis was the current historic cycle’s 1929. There was indeed significant financial and economic stress in 2008/09. But there was definitely no global collapse in Credit or economic activity – no globalized economic depression. Actually, on a global basis debt growth has run unabated. And after a meaningful yet non-catastrophic setback in 2009, global GDP growth quickly recovered. With record outstanding debt, record GDP and near-record securities prices, it’s unreasonable to argue for unending depression-era fiscal and monetary stimulus.
More than a decade ago, Dr. Bernanke, with his “helicopter money” and “government printing press,” arrived on the scene with academic theories to fight the scourge of deflation. Well, the tech Bubble had burst - but I argued strongly at the time that THE greater Credit Bubble was very much alive and well. Extraordinary Fed stimulus was poised to inflate the fledgling mortgage finance Bubble. I argued in 2009 that THE Bubble hadn’t burst, instead unmatched global fiscal and monetary stimulus had unleashed the “granddaddy of them all” – the global government finance Bubble.
This is not “intelligentsia” – and I would add that recent market developments have again made this a most pertinent “debate.” Has the Fed been successfully countering a post-Bubble landscape - or has it instead been further inflating a historic Bubble? Do Dr. Bernanke’s academic theories of how the Fed must ensure there is ample “money” in the real economy to address insufficient demand really hold water? Or have zero rates and Trillions of QE simply flooded excess liquidity into already distorted global securities markets? Has Federal Reserve policy led to runaway Bubbles in dysfunctional risk markets – fueling an epic global “building boom along the river”?
I have in past CBBs noted key differences between the traditional government currency printing press and today’s newfangled electronic version. Traditional monetary inflations created government currency - purchasing power that worked to bid up prices throughout the real economy. The contemporary “printing press” creates electronic debit and credit entries that predominantly provide new purchasing power that bids up prices of financial assets. I have argued that this mechanism has been fueling dangerous securities markets and asset Bubbles around the globe. I have further argued that the Fed and central banks had unwittingly nurtured acute Bubble fragility to any potential reduction in central bank liquidity.
How does one reconcile massive ongoing “money printing” with deflating commodities prices and generally contained consumer price inflation? Well, perhaps the commodities market is the proverbial “canary in the coalmine” warning that QE has indeed fueled increasingly vulnerable Credit and asset Bubbles. The backdrop is increasingly reminiscent of the late-1920s, when many (including the Fed) believed weak commodity prices were a call for further monetary accommodation. I am today playing the role of the “old codgers” from the Roaring Twenties that warned of the dangers (and utter futility) of trying to sustain a deeply maladjusted system and historic financial Bubbles. While they were correct in their analysis, history has been unkind to these “liquidationists” and Bernanke “Bubble poppers.” Dr. Bernanke (and conventional thinking) is convinced the issue during the late-twenties and thirties was deflation and the Fed’s negligence in failing to print sufficient money supply. I am convinced that Bernanke’s analysis is flawed: the key issue was the Fed repeatedly placed “coins in the fusebox” during the twenties – in the process accommodating precarious financial and economic Bubbles.
Quantifying current Bubble risk is an impossible task. Global debt and securities markets easily surpass a hundred Trillion. Gross derivative exposures are in the many hundreds of Trillions. The now enormous Chinese and EM financials systems, in particular, lack transparency. The amount of global speculative leverage is unknown. The degree of global financial distortion and economic maladjustment will not become apparent until the next major period of market risk aversion and resulting tightened global financial conditions. For now, recent market gyrations support my view of precarious Latent Market Bubble Risks.
I’ll attempt to use some data to illustrate how Fed policymaking has greatly exacerbated already outsized market risks. As a crude proxy for “market risk,” I’ll combine outstanding Treasury debt, Agency debt/MBS, Corporate bonds, municipal debt and the value of U.S. equities – securities that fluctuate in the marketplace based upon perceptions of value, liquidity and risk. It is worth noting that “market risk” had inflated to $33 TN during the booming nineties, after beginning the decade at $10 TN. Importantly, the nineties saw a fundamental shift to market-based Credit instruments, with the proliferation of ABS, MBS, the GSEs and “Wall Street Finance” more generally.
I have over the years argued that Credit is inherently unstable. The move to market-based debt instruments created an acutely unstable Credit system, instability that provoked a change at the Federal Reserve to a policy regime committed to backstopping the securities markets. For more than twenty years now, this new policy regime has led to an unending series of Bubbles, booms and busts, even more aggressive policy responses and only bigger, more precarious Bubbles. This is critical analysis that remains completely outside of mainstream economic thinking.
When Dr. Bernanke began his crusade against deflation risk back in 2002, “market risk” was at $29.7 TN. Extraordinary monetary stimulus (and resulting mortgage finance Bubble excess) was instrumental in market risk surging to $53 TN by the end of 2007, before dropping abruptly to $44.8 TN in 2008. During the past four years, “market risk” has inflated $16.7 TN, or 37%, to a record $61.5 TN. Perhaps more illuminating, as a percentage of GDP, “market risk” began the 1990’s at 182% and closed the decade at 323%. Post tech-Bubble asset prices had the ratio back to 284% by the end of 2002. By 2007, however, it had inflated all the way to 378%. In 2009 it fell back to 314%. It then ended 2012 at a record 392%. From another angle, over the past 10 years GDP increased $5.2 TN, or 50%, while “market risk” inflated $31.8 TN, or 107%. While conventional thinking subscribes to the post-2008 deleveraging viewpoint, I believe the data strongly support my re-leveraging and historic Bubble thesis.
Global insurance companies have come to believe that global climate change has made some locations “Uninsurable.” Extraordinary changes in the weather landscape have made areas so prone to potential catastrophe that risks cannot be effectively priced in the insurance market and reserved for by those writing policies.
I will posit that years of central bank intrusion and market domination have made global risk markets “Uninsurable.” “Market risk” has ballooned precariously higher, with massive issuance of non-productive government debt and other late-cycle private-sector Credit excesses. Meanwhile, central bank liquidity injections have inflated global asset market prices, while inciting speculation along with a manic global search for yield. Distorted "Bubble" global economies are increasingly succumbing to the debt and maladjustment overhang, while Financial Euphoria has seen securities markets inflate into dangerous speculative Bubbles.
There is a great flaw in the Bernanke doctrine of inflating the Fed’s balance sheet to both accommodate massive fiscal deficits and inflate securities markets, while using zero rates to force savers into the risk markets. This has led to an unprecedented (and problematic) mispricing of debt and securities prices globally, while incentivizing leveraging and speculation. Trillions of risk-conscious “money” has flowed into global markets (through ETFs, hedge funds, mutual funds, etc.) with little appreciation for the true risk-profile of global financial markets. One could say a Bubble in perceived low-risk “investing” evolved into a key facet of the overall global risk market Bubble.
There remains a perception that risks can be readily hedged and that central banks will ensure liquid markets even in the event that the marketplace moves to de-risk. But the marketplace cannot offload market risk. Risks can be shifted around the marketplace. Yet if the market en masse seeks to reduce risk there is no one with the wherewithal to take the other side of the trade. This issue becomes especially salient when market risks are exceptionally elevated; when risks are underappreciated and misunderstood; and when most (sophisticated speculators, investors and unsophisticated “savers” alike) are heavily committed to the risk markets. That’s where I believe we are today.
Importantly, at least segments of the “global leveraged speculating community” must by now be increasingly impaired. The gold, precious metals and commodities “reflation trade” has been an unmitigated disaster. While not yet a full-fledged disaster, the popular emerging market (EM) trade is unraveling. The currencies and global leveraged “carry trades” have become perilous minefields. Global fixed income markets, more generally, are increasingly unstable and illiquid.
Extremely low market yields and risk premiums/Credit spreads ensured the speculators ramped up leverage in order to achieve their bogey 8-9% (pension fund acceptable) annual returns. The exchange-traded fund (ETF) phenomenon ensured that a couple Trillion flowed easily into all types of mispriced asset classes. The torrent of leveraged buying and ETF flows brought unprecedented liquidity to generally illiquid U.S. corporate and municipal bonds. A torrent of leveraged buying and ETF flows brought unprecedented liquidity to EM markets that over the years earned their “roach motels” moniker. A torrent of flows ensured ultra-easy financial conditions that for four years have worked to validate the (mis)perception of minimal risk throughout U.S. and global markets.
Of course, New York President Dudley and other Fed officials have come out to comfort an unsettled marketplace. Dudley even suggested that the Fed could actually do QE bigger and longer if necessary. Such pandering is precisely why markets are these days so exposed to Bubble risks. The Fed has made such an incredible mess of monetary policy. Fed policies have fomented a historic Bubble and there will no painless extrication. Various Fed officials have said the market has “misinterpreted,” “misunderstood,” and is “quite out of synch” with the Fed’s recent policy message. I don’t believe the market misunderstands the Fed as much as the Fed and market participants for years have misunderstood market risk dynamics.
Bubbles don’t inflate forever. I’ll assume that at least the sophisticated market operators now appreciate the rapidly escalating risk to EM markets and economies. I’ll assume there is newfound appreciation for the serious liquidity issues overhanging various markets. I’ll assume the leveraged players are responding to the new backdrop with plans for reduced leverage and risk. The sophisticated market operators will now work to “distribute” risk to the less sophisticated, a process they expect will be aided by ongoing Fed verbal and QE market support.
Prominent fund managers and bullish pundits have blanketed the airways the past few days with hopeful messages that the worst of the bond selling is over and that the great equities bull market remains intact. It’s just not going to be that easy. Outflows from bond, EM and stock funds have been enormous. Despite this week’s rally, the fear is that investors will be none too pleased when they see monthly/quarterly brokerage statements. The “sophisticated” surely don’t want to be in a situation where they’re fighting the “unsophisticated” to the exits. They need to see that feel-good bull market feeling return to risk markets relatively quickly - or else.
Above I mentioned how Federal Reserve doctrine changed during the nineties to support the proliferation of market-based Credit. During the decade, the market for derivatives and myriad types of risk insurance ballooned right along with Credit and market risk. I’ve argued over the years that Credit and financial market risk are actually Uninsurable – in that they are neither random nor independent events such as car accidents and house fires. Actually, it is the nature of market risk for losses to occur in particularly non-random and non-independent waves. Somehow the lessons of 2008 were quickly unlearned.
And while I’m on the subject of risk management, it’s worth noting that for years one could simply mitigate risk by holding Treasuries (and bunds, agency debt, etc.). In the event of market turbulence, rising Treasury prices would work to offset declining prices for stocks, junk bonds and such. Problematically, Treasury prices have of late been declining right along with risk assets, as “safe haven”, risk asset and commodity prices all turn atypically correlated. There’s been a proliferation of “risk parity” strategies that are struggling under current market conditions. If things don’t normalize quickly, market participants will be forced to adjust their views of risk and liquidity management.
In a way, the Federal Reserve has for years circumvented “nature” by assuring market liquidity. It is this assurance that has empowered a booming derivatives “insurance” marketplace that operates on the specious assumption of “liquid and continuous markets.” The vast majority of derivative market insurance written requires some degree of “dynamic” hedging – i.e. selling of instruments to generate sufficient cash flow to pay on market insurance contracts sold/written. This is one of those key Latent Market Bubble Risks.
Global climate change is fundamentally altering the risk and the insurance marketplace, although “premiums have been kept artificially depressed in the short term because capital has flocked to the sector in the face of historic low interest rates.” Global central banks have unwittingly inflated risk and grossly distorted the risk “insurance” landscape across global risk markets. We’ll see how long “capital” continues to flock to global securities markets. Early indications of how global risk markets will function in the face of a reversal of flows are anything but encouraging.
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