by Doug Noland
I believe it was sometime in late 2002 - or perhaps early 2003. I recall one of the major macro hedge fund managers appearing on CNBC. He made what I thought at the time was an extraordinary comment: "The government wants me to buy junk bonds, so I'm buying junk bonds."
It was always my view that Fed chairman Greenspan directly targeted the leveraged speculating community, as necessary, for use as a mechanism for monetary stimulus/reflation. The Greenspan Fed would actively manipulate market interest-rates, hence speculative profits. If financial crisis erupted - such as with the collapse of Long-Term Capital Management, the bursting of the Tech Bubble, or 9/11 - Greenspan would immediately collapse short-term borrowing costs, assure the marketplace ample liquidity and, accordingly, inflate the price of most fixed income securities.
This signaled to the leveraged players that it was an opportunistic time to buy risk assets - especially corporate debt and mortgages. These purchases would reduce market borrowing costs, increase Credit Availability, and boost marketplace liquidity. And like clockwork, ultra-loose financial conditions would work their magic on the equities and real estate prices, as well as the real economy. After awhile, speculators simply loaded up on risk assets - anticipating the next crisis and Fed-induced speculative profit bonanza.
With the Fed able and willing to manipulate speculative profits and (along with the GSE) "backstop" marketplace liquidity, leveraged speculation flourished and expanded to unimaginable dimensions. The leveraged speculating community evolved into the most powerful monetary force in history - and the Federal Reserve was soon playing with a bonfire.
July 8 - New York Times (Edmund L. Andrews): "Reacting to the violent swings in oil prices in recent months, federal regulators announced... that they were considering new restrictions on 'speculative' traders in markets for oil, natural gas and other energy products. The move is a big departure from the hands-off approach to market regulation of the last two decades. It also highlights a broader shift toward tougher government oversight... In the case of oil and gas trading, regulators made it clear that they were willing to move, without waiting for Congress to act on Mr. Obama's overhaul, invoking their existing powers. The Commodity Futures Trading Commission said it would consider imposing volume limits on trading of energy futures by purely financial investors... 'My firm belief is that we must aggressively use all existing authorities to ensure market integrity,' said Gary Gensler, chairman of the commission... He said regulators would also examine whether to impose federal 'speculative limits' on futures contracts for energy products."
Mr. Gensler's comments really caught the markets off guard. Isn't he a long-time Wall Street, free-markets guy? And while one can view the clampdown on "speculative" energy trading as simply part of the tough new post-Bubble regulatory backdrop, I suspect there's more to it.
The good ole' days of policymakers enticing the leveraged players into junk bonds and mortgages have past. Recall that the Bernanke Fed cut rates 200 bps during 2008's first quarter. Instead of the typical signal to buy US debt securities, speculative flows rushed to trade out of dollar securities for real things that can't be so easily devalued away. Over several months, commodities prices rocketed to record highs, as crude oil reached an astounding $145 a barrel. At that point, the leveraged speculating community had been lost as a reliable Fed monetary management tool. Indeed, the inevitable day had arrived when speculation was viewed as one huge problem in a gigantic mess.
Washington has a dilemma. Unprecedented monetary and fiscal stimulation are being employed in hopes of spurring rapid economic recovery. But these policy measures risk unwieldy - and self-reinforcing - speculative flows out of dollar securities and into "undollar" assets such as energy and commodities. And recall that it was about a month ago that the dollar was breaking down, commodities were on a run, and crude was approaching $75. At that that time, 10-year Treasury yields jumped to almost 4% and MBS yields spiked to 5.07% (up more than 100bps in a month). Housing and economic recoveries were in trouble.
Ironically, stock investors a month back were interpreting the rise in commodities and market yields as positive confirmation that recovery was taking hold. Fast forward a month - with crude and commodities now sinking - and sentiment has shifted somewhat negatively. I tend to hold the view that markets fluctuate - and news/analysis is there waiting to follow market direction. I don't want to over-read commodities price moves as an indicator of the vitality of global reflation.
As expected, the US economy is lodged in deep mud. Europe remains very weak. But the global reflation thesis rests first and foremost upon happenings in China and Asia. China, in particular, is living up to all my reflationary expectations - and then some.
China's preliminary June bank lending data was out this week. Incredibly, loans increased by $224bn. First half loan growth surpassed $1.0 Trillion, about three times the year ago rate and way above government forecasts. As a Credit analyst, these numbers gave me the chills. The Chinese Credit system appears to have commenced the "terminal phase" of Credit excess. Export industries may remain weak, but Chinese housing, auto and equities markets - the current focal point of Credit expansion - are generally robust.
Perhaps Chinese authorities are already moving behind the scenes to try to rein in excesses. Yet a key facet of a Credit Bubble's "terminal phase" is that it becomes a formidable challenge to muscle the Jeanie back in the bottle. Over time, Bubble economies become increasingly unstable. As we witnessed here at home, a point is reached where policymakers view the risks of bursting the Bubble as too great - and they justify and rationalize. Too many - individual and institutions - become dangerously exposed to inflated asset prices. The unbalanced and maladjusted economy becomes acutely vulnerable to a downward spiral. Erratic behavior engulfs assets markets, economic activity and speculative flows, creating confusion and policymaker paralysis. And, especially relevant to the current Chinese predicament, an increasingly unequal distribution of (Bubble economy) wealth creates a volatile social backdrop. When push comes to shove, authorities will generally feed the Credit beast - and the unchecked "terminal phase" is left to run completely out of control.
"Macro" analysis remains as fascinating as it is challenging. Here at home, Washington seems poised to move against unhelpful speculation. The marketplace has good reason to fear heavy-handedness. But don't be surprised if it turns out more a case of light coddling: "Speculators please take notice that it is to your advantage to buy corporate bonds and mortgages instead of oil futures contracts." Fiscal and monetary policymakers are formulating a recovery strategy. I would expect them to pull out all the stops - and not give up easily - in their efforts to accomplish objectives.
And despite the recent bludgeoning meted out in the commodities markets, I'm not keen to abandon the global reflation thesis. At its root, global reflation is premised upon a synchronized global government finance Bubble consequent to bursting Credit Bubbles and the breakdown in the global dollar reserve system. I am comfortable with the thesis yet recognize the analysis is tough and the circumstances fluid. Mostly, uncertainty and market volatility are as expected.
The global system remains in historic, uncharted, troubled and uncertain waters. But with $2 Trillion of US federal debt issuance on tap this year - perhaps matched by upwards of (a previously unimaginable) $2 Trillion of Chinese bank Credit growth - ongoing "Monetary Disorder" remains the best bet. And, of course, our policymakers are keen to this dynamic, and it would be typical of policymakers in such a predicament to resort to increasingly creative means to try to stabilize a desperately unstable pricing system. Can Washington rein in speculative flows? Can they channel and mobilize them?
Doug Noland The Credit Bubble Bulletin PrudentBear.com
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