-->International Perspective, by Marshall Auerback
Attacks from the Periphery
May 11, 2004
âTo preempt inflation fostered by four years of aggressive ease, the Fed must drive a sustained and politically untenable rise in real interest rates. Rate increases cannot be tepid or token. Once inflation becomes entrenched in the industrial economy, financial structure, and public expectations, it is notoriously difficult to root out. The longer the Fed waits, the more severe the market pain. The Fedâs policy dilemma contains the seeds of a prolonged bear market in financial assets. The unwillingness of political leadership to address the fiscal issues surrounding the open-ended financial aspects of terrorism in conjunction with generous entitlement programs is a recipe for expanding debt issuance, which the Fed will be called upon to accommodate. The Fed may continue to bark but it cannot bite.â - John Hathaway, Tocqueville Asset Management, L.P., âInterest Rates and the âDeathâ of Goldâ
During the time of the Japanese shogun-ate, regime changes often developed from the periphery, ultimately culminating with widespread changes in the centre. Financial markets often display the same pattern. Will todayâs current market dislocations in commodity markets, emerging debt markets, Europe and China ultimately contribute to the demise of King Dollar?
Recall that the troubles of Long Term Capital Management began innocently enough when the Thai monetary authorities elected to devalue the baht against the dollar in the spring of 1997. Who would have ever suspected what followed? Similarly, the revulsion evident in emerging bond markets today might ultimately have implications for Wall Street. Likewise, the ongoing efforts by the Bank of England to cool a major housing bubble through repeated rate rises initiated last November.
Part of the recent stress lies in nothing more than what our colleague, Doug Noland, suggested in his most recent Credit Bulletin: namely, that the current tumult is much more associated with the unwinding of trades by the leveraged speculating community, rather than being symptomatic of a huge deflationary tsunami about to sweep up on to American shores. After all, according to syndicated columnist Robert Novak (who allegedly has some of the best sources in Washington):
âThe Bush administration has been alerted that Chairman Alan Greenspan will guide the Federal Reserve Board to a small interest rate boost before the presidential election, and President Bush is reported to be satisfied.
According to these sources, the central bank this fall will raise the federal funds (interbank lending) rate from the current historic low of 1 percent up to 1.25 percent. The Fed is expected to push the rate to 1.5 percent later this year after the election and up to 2 percent early next year.â
If Novakâs sources are correct, this is clearly not the stuff of deflationary nightmares until one considers the backdrop, which has already occasioned so much havoc, notably in the peripheral markets. Brazilian benchmark bond yields surged 158 basis points to 12.85% on Friday, with yields up more than 200 basis points for the week. Russian 10-year Eurobond yields jumped 50 basis points in one day to 6.95%, with a 2-week rise of 106 basis points. Mexican bond yields were up 46 basis points for the day and 71 for the week to 6.61%.
Such deleveraging can ultimately have hugely deleterious economic consequences. We should expect to start seeing the phrase âcontagion effectsâ being hurled across the pages of Wall Street strategistsâ analyses. Note once again, German, UK, Hong Kong and Japan equity indexes are off much more than US indexes, again suggesting that changes at the periphery are lurking closer and closer to US shores, as they gain momentum.
Of course, what we perceive as an economic cancer gathering pace in the nether regions, and rapidly spreading to American shores, is viewed differently by the Pollyannas of Wall Street. They take the view that these attacks from the periphery represent the diseased limbs of the marginal bits of the global economy, easy to lop off and thereby reduce the risk of US contagion. Their argument runs as follows: the US holds the relative economic strength, therefore concentrate equity and currency exposure in the US.
This seems to us to miss the source of the disease, eloquently articulated by Morgan Stanleyâs chief economist, Stephen Roach: âBy digging in its heels and keeping the federal-funds rate negative in real terms, the Federal Reserve has now pushed America firmly into a multiple-bubble syndrome. This is shaping up to be a policy blunder of epic proportions.â This multi-bubble syndrome is the source of much of todayâs financial instability, even as it manifests itself in the periphery. The Pollyannas have it completely backward. Even if Bob Novakâs sources are correct, a 2 per cent interest rate by the beginning of next year will not alleviate the problem if the credit markets continue to run amok.
The recent jobs data appears to confirm Roachâs forebodings. All signs are flashing for a period of robust, perhaps extraordinary, economic growth in the US. Factories are experiencing huge order gains, and have not come close to matching this with production and hiring thus far. This is why supplier deliveries are slowing to an extreme degree, and unfilled order backlogs are inflating at a double-digit annual pace. Inventory/sales ratios in manufacturing are falling at an 8%-10% annual rate. The ISM non-manufacturing survey shows similar conditions have spread into other parts of the economy.
Notes the âeconpundit.blogspot.comâ:
âFirms have been greatly surprised by the sustained, high demand gains, and have understaffed and understocked as a result of their caution. This means we could be just entering a big catch-up phase for output and employment. People should go back and look at the kinds of employment growth we have seen in the past, when ISM figures have been this high -- growth rates of 0.3% per month are common, which given today's labor force size would translate to around 400,000 monthly payroll advances. This could well be repeated now.
Such a surge in job creation would probably cause a spike up in anxiety about the Fed being too slow to raise interest rates, which would be severely negative for global capital markets. As discussed earlier, a loss of Fed credibility on policy (and even the New York Times is already calling for an immediate rate hike!) might cause the bond market to come completely unglued and overshoot massively to the downside, as convexity hedging from the mortgage sector kicked in again.â
As fund manager John Hathaway noted at the top of these pages, the Federal Reserve has been forced into a gradualist position in terms of its conduct of monetary policy, because of the extreme amount of debt that exists now in the system. But this leverage has been persistently accommodated and magnified by the Greenspan Fed which, through its doctrine of asymmetric intervention, has repeatedly flooded the financial system with liquidity once disorderly markets became prevalent and thereby exacerbated the underlying problem. This is fundamentally bearish for US assets, even though the stress currently manifests itself in the periphery.
Some analysts have invoked the analogy of 1994, during which the Fedâs first three rate hikes were done at 25bp increments, but then it shifted to 50bp rate hikes in the next two tightenings before accelerating into a 75bp hike in November of 1994. Anticipating a similar experience, and with so much leverage in the system, todayâs turbo-charged bond market vigilantes may well ponder the question: âWhy should we wait around for the first one to get short now that the Fed has told us it's inevitable?â But things are much worse than in 1994, during which the US was still fresh off a recession a mere 2 years earlier and personal savings were still relatively high. If the data remains super-strong (as implied, for example, last weekâs job data, and ISM non-manufacturing survey), experienced bond managers and analysts may well rush to the exits sooner, creating huge economic dislocation in their wake. Is the Fed truly likely to stay the course (as it did in 1994) with a further 5 or 6 Fed rate hikes?
What truly must haunt the Fed today is that current levels of leverage are so huge that the bond market could blow out before the Fed even gets around to raising rates. There are already signs of this appearing: historically, the bond market has seldom sold off so violently in the absence of rate rises. The 10yr yield now is higher in relation to trailing money market rates than it has ever been in prior to any rate hike by the Fed. And not just by an inconsequential amount, but something in the order of 50-100 basis points. This reflects a profound loss of monetary control on the part of the Fed; the Leviathan of the market is now calling the shots on rates.
Record high U S private indebtedness and sustained large private sector financial deficits has kept the U S private financial structure in a precarious condition. Until recently, it has not got worse rapidly as it did in 2001 when private debt surged, income stagnated, the âfringeâ of the financially distressed exploded, and asset collateral values fell. But as we have noted recently, todayâs financial institutions and the Greenspan Fed has had more instruments to keep the credit spigot open than most of us had hitherto appreciated.
That does not imply that private indebtedness can rise indefinitely; it was only meant to suggest that it might take a significant further rise in private indebtedness to lead to what Charles Kindleberger has termed âa credit revulsionâ. But the ongoing process of deleveraging manifested in the markets over the last couple of weeks does bring this eventuality closer to home shores. And the American patient, meanwhile, is in much worse shape. We have not unwound the valuation excesses of the bubble years; there is much unfinished business left to be done. If the bear trend in the market, (which is still intact on the big picture charts) resumes, if the bond market were to come apart, it could abort the ongoing economic recovery, and that might create the conditions in which a persistent high private financial deficit could lead to a credit revulsion on the part of foreigners, as they come to recognise the house of cards that constitutes the current US credit system.
What is so striking about the current environment is how remarkably schizophrenic have appeared the respective reactions of bond and equity investors. Bonds could very well crash now without the Fed doing a blessed thing because some of its own members, as well as leading âbond market vigilantesâ such as PIMCOâs Bill Gross, have now conceded that the US central bank has a huge tightening job to do and hasnât even started the process of ânormalisingâ rates. Equity investors, by contrast, remain remarkably sanguine, if last weekendâs 60%/12% bull to bear ratio in the Barron's poll is a genuine reflection of sentiment (And, for more traditionalists, the VIX is only just beginning to break out again to the upside as we slice through the March 2004 equity index lows.) The Fed, via Messrs Greenspan and Bernanke, has already conceded that it is prepared to live with a certain amount of inflation in order to avoid deflation. However, we are in uncharted territory now as far as the degree to which the mar
kets perceive the Fed is behind the curve on tightening vs. the length of time they think it will take for them to get neutral, and also (critically) the amount of leverage in the system.
The great paradox is that equity investors need to be shaken up further in order to calm the bond markets and thereby reduce the threat of systemic stress. A few more days like yesterday and perceptions will grow that the declining âwealth effectâ from a falling stock market will reduce the need to tighten precipitously. In fact, a further horrendous slide in the stock market might actually shift market sentiment back in the direction of ease, which would in turn resume the process of dollar decline and thereby afford Asian central banks the chance to offer a lending hand by placing a bid under the bond market in order to preclude a crash in the greenback. The Fed and their political masters are praying that the pressure for monetary restraint will fall away naturally, via more moderate business growth and inflation signals, and that will keep the bond market vigilantes passive.
Of course, if the bond market vigilantes continue to run rampant, this creates distinct potential for the nightmare scenario: bond yields keep spiking higher, as the Fed's credibility continues to decline amid robust economic activity reports and a widening gulf between the presumed neutral and actual Fed Fund rates. In turn, the higher yields ultimately crash the stock and commodity markets, and those developments let out a ton of steam from the bond pressure cooker. But by turning down equity values in a big way (20%? 25% 30? more?), the bond yield spike will also turn the big, slow ship of housing demand and prices downward for the first time, and that change will pick up momentum over time and will prove impossible for the authorities to arrest. If this doesnât set the stage for a massive credit revulsion, it is hard to imagine what will. The credit bubble may burst at that stage and with it, the eruption of much more systemic risk, the barest outlines of which are seen from the periphery today.
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