For the week, the S&P500 sank 7.2% (down 4.6% y-t-d), and the Dow fell 5.8% (down 1.1%). The Banks fell 10.0% (down 20.7%), while the Broker/Dealers dropped 9.5% (down 21.5%). The Morgan Stanley Cyclicals fell 10.8%% (down 13.5%), and the Transports dropped 9.4% (down 8.1%). The Morgan Stanley Consumer index declined 5.2% (down 6.8%), and the Utilities lost 3.4% (up 1.7%). The S&P 400 Mid-Caps were hit for 10.5% (down 6.9%), and the small cap Russell 2000 was down 10.3% (down 8.8%). The Nasdaq100 fell 7.1% (down 1.1%), and the Morgan Stanley High Tech index dropped 7.6% (down 11.6%). The Semiconductors sank 9.5% (down 14.7%). The InteractiveWeek Internet index dropped 8.1% (down 8.8%). The Biotechs sank 15.7% (down 12.1%). Although bullion jumped $36, the HUI gold index fell 3.0% (down 8.1%).
One-month and three-month Treasury bill rates ended the week at one basis point. Two-year government yields declined 8 bps to 0.29%. Five-year T-note yields ended the week down 11 bps to 1.25%. Ten-year yields fell 24 bps to 2.56%. Long bond yields sank 27 bps to 3.85%. Benchmark Fannie MBS yields declined 17 bps to 3.64%. The spread between 10-year Treasury yields and benchmark MBS yields increased 7 to 108 bps. Agency 10-yr debt spreads increased 8 to about zero. The implied yield on December 2012 eurodollar futures dropped 6 bps to 0.665%. The 10-year dollar swap spread increased 4 to 16.75 bps. The 30-year swap spread increased 5 bps to negative 27 bps. Corporate bond spreads widened. An index of investment grade bond risk increased 7 bps to 103 bps. An index of junk bond risk jumped 86 bps to 582 bps (high since August 2010).
Investment-grade issuers included Coca-Cola $2.0bn, JPMorgan $1.25bn, Kinder Morgan Energy Partners $750 million, Lorillard Tobacco $750 million, Union Pacific $500 million, Dominion Resources $500 million, Hyatt Hotels $500 million, National Agriculture $500 million, Energen $400 million, MF Global $325 million, Reckson $250 million, Public Service Colorado $250 million, and Southwester Public Service $200 million.
Junk bond funds saw outflows of $804 million (from Lipper). I saw no junk debt issued this week.
I saw no convertible debt issued.
International dollar bond issuers included National Australia Bank $1.85bn and Ballarpur $200 million, .
German bund yields dropped 19 bps to 2.345% (down 62bps y-t-d), and U.K. 10-year gilt yields fell 17 bps this week to 2.69% (down 82bps). Greek two-year yields ended the week up 90 bps to 32.51% (up 2,028bps). Greek 10-year note yields rose 38 bps to 14.86% (up 240bps). Italian 10-yr yields jumped 22 bps to 6.08% (up 127bps), while Spain's 10-year yields declined 3 bps to 6.03% (up 59bps). Ten-year Portuguese yields gained 12 bps to 10.67% (up 409bps). Irish yields dropped 81 bps to 9.81% (up 76bps). The German DAX equities index dropped 12.9% (down 9.8% y-t-d). Japanese 10-year "JGB" yields declined 8 bps to 1.00% (down 12bps). Japan's Nikkei fell 5.4% (down 9.1%). Emerging markets were hit. For the week, Brazil's Bovespa equities index sank 10.0% (down 23.6%), and Mexico's Bolsa dropped 6.4% (down 12.6%). South Korea's Kospi index sank 8.9% (down 5.2%). India’s equities index fell 4.9% (down 15.6%). China’s Shanghai Exchange declined 2.8% (down 6.5%). Brazil’s benchmark dollar bond yields fell 12 bps to 3.62%, and Mexico's benchmark bond yields dropped 17 bps to 3.53%.
Freddie Mac 30-year fixed mortgage rates sank 16 bps to 4.39% (down 10bps y-o-y). Fifteen-year fixed rates were down 12 bps to 3.54% (down 41bps y-o-y). One-year ARMs rose 7 bps to 3.02% (down 53bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down two bps to 4.98% (down 48bps y-o-y).
Federal Reserve Credit declined $3.4bn to $2.850 TN. Fed Credit was up $442bn y-t-d and $540bn from a year ago, or 23.4%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 8/3) jumped $10.1bn to $3.463 TN. "Custody holdings" were up $113bn y-t-d and $309bn from a year ago, or 9.8%.
Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg – were up $1.613 TN y-o-y, or 19.0% to a record $10.096 TN. Over two years, reserves were $3.07 TN higher, for 42% growth.
M2 (narrow) "money" supply jumped another $22bn to a record $9.315 TN. "Narrow money" has expanded at a 9.4% pace y-t-d and 8.1% over the past year. For the week, Currency increased $2.1bn. Demand and Checkable Deposits rose $19.3bn, and Savings Deposits added $1.4bn. Small Denominated Deposits declined $3.9bn. Retail Money Funds increased $3.1bn.
Total Money Fund assets dropped $66bn last week to $2.568 TN. Money Fund assets were down $242bn y-t-d, with a decline of $250bn over the past year, or 8.9%.
Total Commercial Paper outstanding sank $31.7bn to $1.173 Trillion. CP was up $204bn y-t-d, or 29% annualized, with a one-year rise of $76bn.
Global Credit Market Watch:
August 5 – Bloomberg (John Detrixhe): “The U.S. had its AAA credit rating downgraded for the first time by Standard & Poor’s, which slammed the nation’s political process and said lawmakers failed to cut spending enough to reduce record deficits. S&P dropped the ranking one level to AA+, after warning on July 14 that it would reduce the rating in the absence of a ‘credible’ plan to lower deficits even if the nation’s $14.3 trillion debt limit was lifted. The U.S. was awarded the top credit ranking by New York-based S&P in 1941. It kept the outlook at “negative” amid the failure to end Bush-era tax cuts. ‘The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics,’ S&P said…”
August 4 – Bloomberg (Simone Meier): “Bundesbank President Jens Weidmann opposed the European Central Bank’s decision to resume bond purchases today… ECB President Jean-Claude Trichet told a press briefing in Frankfurt that while the decision was not unanimous… Germany’s Bundesbank, under then president Axel Weber, opposed the ECB’s initial decision to start buying the bonds of distressed euro-area governments in May last year, opening a rift with Trichet and other ECB policy makers. The ECB, which ceased purchases 18 weeks ago, re-entered markets today after Italian and Spanish yields soared to euro-era records.”
August 3 – Bloomberg (Jeffrey Donovan): “Italian opposition leader Pier Luigi Bersani said Italy ‘is in big trouble’ and needs a change of leadership to restore credibility to its political system and win back the confidence of investors.”
August 4 – Dow Jones (Prabha Natarajan): “High-yield investors, who had been immune to the broader market worries for so long, are starting to capitulate and sell. ‘Some European accounts are getting nervous and selling some good-quality bonds,’ said Adrian Miller, senior vice president of fixed-income strategy at Miller Tabak Roberts Securities. ‘This is catching on with some domestic accounts also seeking cash,’ he said.”
August 3 – Bloomberg (Lisa Abramowicz): “Trading in high-yield bonds plummeted to the lowest level in three years as investors fled from riskier assets on concern that a sovereign debt crisis was spreading to the U.S. from Europe. About $3.7 billion of publicly traded junk debt exchanged hands daily on average in the U.S. during July… That compares with a daily average of $4.3 billion last July and $5.4 billion for July 2009…”
Global Bubble Watch:
August 1 – Bloomberg (Michael Patterson): “Banks in the biggest emerging markets are losing the confidence of investors as loans turn sour after a two-year credit binge. Brazil’s financial shares have lost more this year than counterparts in crisis-stricken Europe as consumer defaults hit a 12-month high in June and borrowing costs climbed to 46%. Bank stocks in China are trading at lower valuations than global emerging-market indexes for the first time since 2006…. ‘People are beginning to smell the credit cycle turning,’ Michael Shaoul, chairman of Marketfield Asset Management and chief executive officer of… Oscar Gruss & Son, said… ‘Credit cycles have tremendous momentum, and whenever they turn you want to pay attention…’”
August 3 – Bloomberg (Patricia Kuo and Stephen Morris): “Private-equity firms face funding costs for European leveraged buyouts that exceed even the aftermath of Lehman… collapse as a weakening global economy and Europe’s debt crisis damp demand for high-yield, high-risk loans. Interest rates on loans to finance LBOs have risen to average 450 bps more than benchmarks since June, from 413 bps in the first five months… Margins peaked at about 437 bps following Lehman’s bankruptcy in late 2008.”
August 3 – Bloomberg (David Wilson): “Private companies in the U.S., like the federal government, have to deal with a rising debt burden as the country’s economy struggles to grow. …During this year’s first half, the ratio [the average ratio of debt to earnings before interest, taxes, depreciation and amortization, a gauge of cash flow for closely held enterprises} climbed by 0.62 times Ebitda to 5.83. The surge is more than twice the biggest full-year advance: 0.22 times, recorded in 2003 and 2008.”
August 4 – Dow Jones: “Finance Minister Evangelos Venizelos said… that Europe's currency bloc is facing an ‘organized attack’ in the financial markets after investor jitters sent Italian and Spanish bond yields to record highs this week. ‘In the last few days the euro zone has been facing an organized attack against its core,’ Venizelos said… to the Greek parliament. ‘At this moment, big countries, countries that dominate, not just the European but also the global economy--such as Italy, such as France, such as Spain--countries that are among eight biggest in the world, are facing an unprecedented [increase] in their cost of capital… The cost of their public borrowing is exploding.’”
Currency Watch:
July 28 – Bloomberg (Paul Panckhurst): “Senior Chinese officials are ‘appalled’ by the impasse among U.S. politicians on raising the nation’s debt ceiling to avoid a default, said Stephen Roach, non-executive chairman of Morgan Stanley Asia Ltd. ‘Coming so shortly on the heels of the subprime crisis, the debate over the debt ceiling and the budget deficit is the last straw’ for China… Roach said…”
The U.S. dollar index increased 0.9% this week to 74.60 (down 5.6% y-t-d). For the week on the upside, the Swiss franc increased 2.4%. On the downside, the Australian dollar declined 5.0%, the New Zealand dollar 4.1%, the South African rand 3.4%, the Canadian dollar 2.7%, the Mexican peso 2.1%, the Japanese yen 2.1%, the Norwegian krone 1.8%, the Brazilian real 1.7%, the South Korean won 1.2%, the Singapore dollar 1.1%, the euro 0.8%, the Danish krone 0.8%, the Taiwanese dollar 0.3%, and the British pound 0.2%.
Commodities and Food Watch:\
August 3 – Wall Street Journal (Se Young Lee and In-Soo Nam): “South Korea's move to buy gold for the first time in 13 years is the latest in a growing trend of central banks diversifying their reserves and reducing dependence on the U.S. dollar as the reserve currency comes under greater scrutiny.”
The CRB index dropped 4.5% this week (down 1.8% y-t-d). The Goldman Sachs Commodities Index sank 5.9% (up 2.2%). Spot Gold rose 2.2% to a record $1,664 (up 17.1%). Silver sank 4.4% to $38.33 (up 24%). September Crude was hit $8.59 to $87.11 (down 5%). September Gasoline sank 7.8% (up 15%), and September Natural Gas fell 4.6% (down 10%). September Copper was hit for 8% (down 7%). September Wheat increased 1.0% (down 15%), and September Corn jumped 4.1%(up 10%).
China Bubble Watch:
August 2 – Bloomberg (Fion Li): “Yuan-denominated debt sales in Hong Kong dropped to a four-month low in July as Moody’s… warned of governance concerns at Chinese companies and Europe’s debt crisis cooled demand for emerging-market assets. Sales of so-called dim sum bonds totaled 9.4 billion yuan ($1.5 billion), down from 15.2 billion yuan in June, 30.1 billion yuan in May… The securities… handed investors a 0.4% loss after declining 1.0% in June…”
August 1 – Bloomberg (Angela Greiling Keane): “China’s home prices rose at the slowest pace in 11 months in July after the government expanded efforts to curb the risk of an asset bubble, according to SouFun Holdings Ltd. Home prices gained 0.2% in July from June… Residential prices increased in 66 out of 100 cities tracked… with average home values nationwide climbing to 8,874 yuan ($1,378) a square meter (10.76 square feet)…”
Latin America:
August 1 – Bloomberg (Ye Xie and Bryan Gibel): “Investor confidence in Brazil’s central bank and Finance Ministry is flagging. Local bonds posted the biggest weekly decline in six months after the central bank signaled it may be done raising interest rates to curb inflation and the government levied a new tax on currency trading.”
Unbalanced Global Economy Watch:
August 1 – Bloomberg (Jana Randow): “European unemployment held steady for a fourth month… The 17-nation euro region’s seasonally adjusted jobless rate remained at 9.9%...”
August 1 – Bloomberg (Jonas Bergman and Toby Alder): “Swedish manufacturing slowed to a standstill after 25 months of growth as domestic and export orders declined in the largest Nordic economy.”
August 1 – Bloomberg (Michael Heath): “A gauge of Australian manufacturing slumped to a two-year low last month as a surging currency and the highest borrowing costs in the developed world hurt demand at home and abroad.”
August 2 – Bloomberg (Zainab Fattah): “Saudi billionaire Prince Alwaleed bin Talal chose Saudi Binladin Group to construct a building in Jeddah that will replace Dubai’s Burj Khalifa as the world’s tallest tower. Kingdom Tower will be more than 1,000 meters (3,281 feet) high and cost 4.6 billion riyals ($1.2 billion) to build…”
U.S. Bubble Economy Watch:
August 3 – Associated Press: “Unemployment rates rose in more than 90% of U.S. cities in June, mirroring a national slowdown in hiring. ...unemployment rates rose in 345 large metro areas. They dropped in 20 cities and were unchanged in seven. That's worse than May, when rates rose in only 210 cities. And it is a sharp reversal from April, when unemployment rates fell in nearly all metro areas.”
August 3 – Bloomberg (Bob Willis): “Spending on services, the biggest part of the U.S. economy, has barely budged in the two years since the recession ended as ‘distressed’ households hold the line on everything from vacations to restaurant visits. … spending on services adjusted for inflation has increased 2.2% since the economic slump ended and the recovery began in June 2009.”
Fiscal Watch:
August 3 – New York Times (Binyamin Appelbaum): “There is something you should know about the deal to cut federal spending that President Obama signed into law…: It does not actually reduce federal spending. By the end of the 10-year deal, the federal debt would be much larger than it is today. Indeed, both the government and its debts will continue to grow faster than the American economy, primarily because the new law does not address federal spending on health care. That is the reason that the ratings agency Standard & Poor’s and its rivals still are threatening to remove the United States from their lists of risk-free borrowers, although the other agencies, Moody’s and Fitch, both said Tuesday that they would watch and wait for now.”
July 28 – Bloomberg (Gopal Ratnam and Roxana Tiron): “Lockheed Martin Corp., Northrop Grumman Corp. and other top U.S. defense contractors are preparing for deeper defense cuts and budget delays by reducing costs and eliminating jobs in a bid to keep shareholder profits from shrinking. Lockheed, the world’s largest defense contractor, already has announced about 3,850 job cuts starting last year and is seeking more. The… maker of F-35 jets promised investors on July 26 that 2011 profit will be higher than earlier estimates, driven by higher operating margins -- a result of cost-cutting measures.”
August 3 – Bloomberg (Angela Greiling Keane): “The U.S. Postal Service, which expects to run out of money next month, widened its loss forecast for the year to $9 billion. The service, which says it will reach its $15 billion debt limit in September, increased its prediction for the fiscal year… previously said it would lose $8.3 billion, after an $8 billion loss a year earlier.”
Real Estate Watch:
August 3 – Bloomberg (Sarah Mulholland): “Late payments on commercial mortgages bundled and sold as bonds rose the most in more than 12 months, adding to concern that the market is deteriorating three years after the financial crisis choked off funding to borrowers. Delinquencies on the debt jumped 51 bps in July to a record 9.88%, according to… Trepp LLC…. ‘Much of the positive momentum that had been surrounding the CMBS market recently has now all but vanished in the past few weeks,’ according to… Trepp.”
August 2 – Bloomberg (Nadja Brandt): “High-end hotels in large U.S. cities are attracting buyers from Hong Kong, China and Singapore seeking to cater to a growing number of affluent Asians traveling abroad… The most recent transaction came last week, when the family of Hong Kong billionaire Cheng Yu-Tung purchased five luxury properties, including Manhattan’s Carlyle, for $570 million.”
Speculation Watch:
August 4 – Bloomberg (Kelly Bit and Saijel Kishan): “John Paulson, the money manager who earned about $5 billion in 2010, lost 4.6% in his biggest fund in July… The decline left Paulson’s Advantage Plus Fund, which uses strategies designed to profit from corporate events such as takeovers and bankruptcies, down 22% this year…”
Destabilizing Speculation:
“Thinkers” of things economic have for a long time debated the role profit-seeking speculators play in the marketplace. Milton Friedman famously contended that there really wasn’t such a thing as “destabilizing speculation.” On the contrary, he and others viewed speculators as a positive force in the markets - whose “buy low and sell high” profit motive tended to exert a stabilizing force. Today, European policymakers believe they are under attack from speculators determined to bring down their debt markets and currency regime. At this point, I doubt there are many that would downplay the integral role speculation plays in our dangerously unstable global markets.
But let’s give the “no destabilizing speculation” thesis its due. Actually, in largely contained and self-regulating Credit systems, speculation may indeed provide a stabilizing influence. Think in terms of a gold standard where an economic system is demonstrating lending and spending excesses - along with attendant current account deficits. If the marketplace appreciates that an outflow of gold would pressure interest rates higher thus imposing system restraint, speculators will be incentivized to place their bets accordingly (short bonds, for example). Their activity will work to assist the system’s self-adjustment process.
Or, let’s ponder a Credit system restrained not by a backing of gold but instead through principled and disciplined policymaking. Here, policy doctrine has credibility in the marketplace. In the event that excess begins to emerge, market participants will factor in the inevitability of a policy response. If the marketplace knows that lending, asset price inflation and a deteriorating current account position will elicit monetary tightening, then speculators will position for such a tightening as the signs of excess begin to emerge. If, on the other hand, signs of lending restraint, economic weakness and risk aversion surface, speculative bets on imminent “easing” (i.e. long stocks and bonds) would similarly work to support the system’s self-adjustment process. In short, if the markets appreciate that there are reliable mechanisms to counter the emergence of overly loose or overly tight financial conditions, then speculators in reality would be expected to place their bets in a manner that would generally be in concert with system stabilization (others would use the word “equilibrium”).
Alan Greenspan was a major proponent of the hedge fund community. He repeatedly asserted that the burgeoning leveraged speculating community was a positive force, enhancing the efficiency of the free market process and generally improving marketplace liquidity and the allocation of precious savings. The 1994 bond market rout and 1998 LTCM fiasco should have - but did not - dissuade this view.
Over the years, the “leveraged speculating community” became a critical factor for monetary policy. I have referred to “the most powerful monetary transmission mechanism in the history of central banking.” And I do believe that the Greenspan/Bernanke Fed has been quite cognizant of the role of leveraged speculation. Through pegging short-term borrowing costs and clearly telegraphing how policy would respond to heightened systemic stress, the Fed was instrumental in the incredible growth in global leveraged speculation. And with a brief statement or a little 25 bps rate reduction, the Fed had attained the power to immediately incite risk-taking, leveraging, higher asset prices and, accordingly, loosened financial conditions (not your granddad’s monetary mechanism). The interplay between central bankers and the leveraged speculators (hedge funds, proprietary trading desks, etc.) has been instrumental to the expansive global Credit Bubble.
Central to my analytical framework has been the thesis that the current extraordinary global Credit backdrop is unique historically. For the first time, global finance operates with no limits to either the quantity or quality of new credit creation. There is no gold standard; no Bretton Woods currency management regime; nor even an ad hoc dollar-reserve system to anchor Credit expansion.
Unconstrained finance is nirvana for speculation. Importantly, boundless Credit completely abrogates a system’s capacity to self-adjust. As we saw with the Bubble in mortgage (and Greek, Portuguese, Irish, Spanish, Italian…) Credit and now with Treasury debt, an enormous jump in the demand for Credit can be easily accommodated in the marketplace - even at declining interest rates. Why? Because unrestrained finance allows the supply of Credit to easily inflate to match heightened demand – with the cost of finance (the interest rate) determined much more by monetary policy than through a functioning market pricing (supply vs. demand) mechanism. In a variant of the old “Say’s Law,” contemporary finance enjoys the extraordinary capacity for the demand of Credit to create its own (highly elastic) supply – at a price chiefly determined by central bankers.
Importantly, unrestrained finance creates a backdrop where speculation will tend towards being destabilizing. Credit excess begets Credit excess. System Credit growth supports higher asset prices and stronger economic activity, which then promote additional Credit excess. Credit expansion will entice speculation on higher asset prices that, especially in a world of unrestrained finance, promotes additional trend-reinforcing Credit and speculative excess. Instead of speculation working alongside the system’s self-adjustment process, it decisively exacerbates the system’s proclivity for runaway excess. And if “activist” policymaking works to ensure that excesses are not allowed to be wrung out the system – well, you’ve fomented a very serious “destabilizing speculation” problem.
The 2008 crisis was devastating for the leveraged speculating community. Thousands of hedge funds closed shop, while general confidence in their structure was badly shaken. I thought one positive outcome from the crisis would be a much smaller and less destabilizing speculating community. It was not to be. In less than two years, hedge fund assets surpassed a record $2.0 Trillion. Wall Street “prop desks” were simply spun off to the unregulated hedge fund realm. Amazingly, global markets became more speculative and dysfunctional than ever.
It was not my intent to write a “theoretical” piece. Very important developments have unfolded, and I’m just hoping to shed a little analytical light. I have argued the “global government finance Bubble” thesis for 25 months now. A crack that commenced with Greece in April 2010 has recently become a huge issue.
Hedge fund de-leveraging was surely a primary factor behind this week’s market tailspin. The community is again on the wrong side of rapidly moving markets, and they’re being forced (voluntarily or by the “margin clerk”) to liquidate positions and rein in risk. Most pundits will ignore or downplay the significance of the speculators again running into trouble: “Those silly hedge funds. Let them unwind positions quickly so we can get back to the business of a bull market.” Publicly, many leading market commentators (including a few hedge fund “titans”) have remained unwavering bulls.
The leveraged speculating community has played a pivotal if unappreciated role in the post-2008 “global government finance Bubble.” The unprecedented global monetary and fiscal response incited re-risking and re-leveraging. Policy measures to reflate asset markets and stimulate economic recoveries created extraordinary opportunities for sophisticated market operators to garner incredible speculative profits. At the same time, the Fed’s zero rate policy induced huge flows out of low-yielding savings vehicles and into higher-returning risk assets and vehicles – certainly including the hedge fund community. Despite the 2008 fiasco, government policies inflated both fund returns and fund inflows, directly reflating the speculative Bubble in leveraged speculation.
First, massive fiscal stimulus ensured a recovery of both economic activity and corporate profits (and stock buybacks and M&A!). Second, with zero rates and the assurance of liquid markets, the Fed and other central bank virtually guaranteed a robust inflationary bias for securities markets generally. And third, an extraordinary combination of fiscal and monetary stimulus in the U.S. ensured powerful devaluation dynamics for the U.S. dollar – and resulting strong inflationary biases in virtually everything non-dollar. Somewhat ironically, the collapse of the mortgage/Wall Street Bubble incited “the gilded age in global leveraged speculation.”
The critical issue now is whether this Bubble has been pierced - or just suffered a setback. My view is that it has likely burst. There is today great uncertainty - a global crisis of confidence in policymaking, financial institutions, and the markets – and it will be no easy task to restore confidence. Once the forces of de-leveraging are unleashed, there is powerful momentum toward system instability. I expect this momentum will be especially difficult for policymakers to quell in a sovereign debt crisis backdrop.
First of all, the basic premise behind the re-emergence of post-’08 flows to the leveraged speculating community was that the funds would reliably generate strong investment returns. Especially with respect to the large and established funds, the thought was that if they survived 2008’s “hundred-year flood” they were “good to go” for quite a multi-year run. This past week’s market tumult pushed industry returns from disappointing to potentially terrible.
And at the fund level, it was assumed that post-crisis policymaking had significantly skewed the market risk versus return backdrop in the hedge funds’ favor. Policymakers were poised for an extended period of extreme stimulus, and policy was as well prepared to respond aggressively in order to safeguard market and economic recoveries. It was “moral hazard” and “systemic too big to fail” on an unprecedented global scale. The Bubble that unfolded was premised on the ongoing efficacy of policy stimulus – the efficacy of political processes and global monetary management. The “bulls” and speculators had been deeply emboldened.
My premise has been that the unfolding sovereign debt crisis would expose important market misconceptions, especially in regard to the efficacy of government policies to rectify government debt problems. Sovereign debt crises are a much different animal than private-debt crisis, and market complacency was in for a rude awakening. Importantly, some basic premises behind the Bubble in leveraged speculation would be disproved. Instead of controlling and reducing risk, the policymaking backdrop had in fact greatly increased market risk. Rather than leverage providing a mechanism to capitalize on policy-induced market “inefficiencies,” the leveraged players had been induced into another precarious Bubble environment. Instead of guaranteeing marketplace liquidity, the government-induced Bubble had ensured inevitable liquidity problems.
European policymakers are pilloried for their inability to deal with their escalating debt crisis. Well, a global sovereign debt crisis has been brewing for years. There are no easy solutions. The world is today inundated with debt lacking the backing of real economic wealth or wealth-creating capacity. Trillions upon Trillions of debt will not be repaid – and markets are frustrated that it is increasingly difficult for politicians to “kick the can”… “extend and pretend.” Meanwhile, at this late stage of the Credit cycle aggressive fiscal and monetary stimulus is largely an expended force. Speculators have until recently taken great comfort in the reality that it has required overwhelming stimulus just to stabilize highly maladjusted market and economic systems. Have we reached the point where the sophisticated players recognize that extreme policymaking has gone from supporting leveraged speculation to manifesting intolerable uncertainty and instability?
In the category of “be careful what you wish for,” global policy responses to the escalating crisis have of late acted only to further destabilize the currency markets. For awhile now, nowhere has policy seemingly created more certainty – hence speculative opportunity – than in the currencies. Washington has essentially guaranteed ongoing dollar devaluation, and the weak dollar has been instrumental to the global Bubble. The scope of dollar short positions – including sophisticated derivative speculations derived from interest rate differentials – is unknown but likely huge. This week it seemed that a short position against the dollar became less of a sure bet, a point made clear by policy moves from the Swiss, Japanese and ECB.
Today, the speculator community must have one eye on the debt markets and the other on the currencies – with nervous glances back and forth to unstable equities, commodities and the emerging markets. And now that de-risking and de-leveraging have begun in earnest – and with losses accumulating rapidly – the fear will be of de-leveraging begetting liquidity issues and only more de-leveraging. And, of course, today’s dog-eat-dog environment ensures that operators will now seek to profit (by selling first/"front running") from those needing to sell – after a couple of years of seeking to profit (buying first) from those that needed to buy. And there will be the issue of hedge fund redemptions, with the distinct possibility that industry fundamentals have recently taken a dramatic turn for the worse. And throw in the lingering problem with derivatives, ETFs and other instruments that create heightened risk of trend-reinforcing trading to the downside. Resulting uncertainty, tightened financial conditions and waning confidence portend economic disappointment – and the makings for burst Bubbles and bear markets.