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“The Pig In The Python Is About To Be Expelled”: A Walk Thru Of China’s Hard Landing, And The Upcoming Global Harder Reset | Zero Hedge

“The Pig In The Python Is About To Be Expelled”: A Walk Thru Of China’s Hard Landing, And The Upcoming Global Harder Reset | Zero Hedge.

By now everyone knows that the Chinese credit bubble has hit unprecedented proportions. If they don’t, we remind them with the following chart of total bank “assets” (read debt) added since the collapse of Lehman: China literally puts the US to shame, where in addition to everything, the only actual source of incremental credit growth over the same time period has been the Fed as banks have used reserves as margin for risk purchases instead of lending.

 

Everyone should also know that like a metastatic cancer, the amount of non-performing, bad loans within the Chinese financial system is growing at an exponential pace.

 

Finally, what everyone learned over the past month, is that as the two massive, and unresolvable forces, come to a head, the first cracks in the facade are starting to appear as first one then another shadow-banking Trust product failed and had to be bailed out in the last minute.

However, as we showed last week, and then again last night, the default party in China is only just beginning as Trust failures in the coming months are set to accelerate at a breakneck pace.

 

The $64K question is will the various forms of government be able to intercept and bail these out in time, as they have been doing so far despite their hollow promises of cracking down on moral hazard: after all, everyone certainly knows what happened when Lehman was allowed to meet its destiny without a bailout – to say that the CNY10 trillion Chinese shadow banking industry will not have far more dire consequences if allowed to fall without government support is simply idiotic.

But what could be the catalyst for this outcome which inevitably would unleash the long-overdue Chinese hard landing, and with it, a new global depression?

Ironically, the culprit may be none other than the Fed with the recently instituted taper, and the gradual, at first, then quite rapid unwind of the global carry trade.

Bank of America explains:

QE and the Emerging Markets carry trade

 

The QE channel has worked through Emerging Markets and China is a key vehicle. By lowering the US government bond yields to a bare minimum, and zero –ish at the short end, a search for yield globally ensued. Emerging market banks and corporates have gone on an international leverage binge, yet another carry trade, the third in 20 years. The first one was driven by European banks, financing East Asian capex – that ended in 1997. The second one was global banks and equity-FDI supporting mainly capex in the BRICs. That ended in 2008. This time, it is increasingly non-equity: commercial banks and more importantly, the bond market – often undercounted in the BoP and external debt statistics that conventional analysis looks at.

 

Chart 9 shows the rise of EM external loans and bond issuance (both by residence and nationality). Since, end-3Q2008 to end-3Q2013, external borrowing from banks and bonds has risen USD1.9tn. Bank loans have risen by USD855bn and bond issuance in foreign currencies by nationality is up USD1,042bn. In the prior five-year period (i.e. end-3Q2003 – end-3Q2008), forex bond issuance rose only USD432bn. Clearly, the importance of external bond issuance is rising. See Table 5 for details.

 

In China, since, end-3Q2008 to end-3Q2013, outstanding external borrowing from banks and bonds has gone from USD207bn to USD849n – a net rise of USD655bn. Outstanding bank loans are up from USD161bn to USD609bn – a net rise of USD464bn. Bond issuance in foreign currencies by nationality is up from USD46bn to USD240bn – a net rise of USD191bn. In the prior five-year period (ie, end-3Q2003 – end-3Q2008), forex bond issuance rose only USD28bn in China. Clearly, the importance of external bond issuance is rising in China.

 

 

There is more to this story.

 

As mentioned earlier, for externally-issued bonds, USD1,042bn has been raised by the nationality of the EM borrower since end-3Q 2008, but USD724bn by residence of the borrower – a gap of USD318bn, or 44%. This undercount is USD165bn in China, USD100bn in Brazil, USD62bn in Russia, and USD37bn in India. The carry trade this time around was helped substantially by access to the bond market, especially from overseas affiliates of EM banks and corporations.

 

There are a lot of moving parts in the balance of payments that finally affect the change in international reserves at any EM central bank – eg, the current account, portfolio equity investment and direct equity investment, and debt flows – both from the bond market and lending from banks. We focus on the link between these debt flows and the international reserves in China. As Table 5 below shows, China’s external debt – from bond issuance and forex borrowing from banks – rose USD655bn during 3Q08-3013.

 

 

We posit that this large rise was in part driven by the carry trade offered up by QE – China banks and corporates issued substantial forex-denominated bonds, and borrowed straight loans from international banks. We recognize the caveat that correlation does not imply causation. The USD655bn rise in China debt issuance is highly correlated to the Fed’s balance sheet since late-2008. As Chart 11 shows, the rise in China debt issuance of USD 655bn has (along with FDI and the C/A surplus), boosted international reserves by USD1,773bn since late-2008. Also, as Chart 11 shows, the USD1,773bn rise in China international reserves mirrors the rise of USD2,585bn in the EM monetary base. Lastly, the rise of China’s monetary base of USD2,585bn correlates well with the USD10.9tr rise in China’s broad money expansion.

 

 

 

As the Fed tapers, and the size of its balance sheet stabilizes/contracts, we should expect this sequence to reverse. Confidence is a fragile membrane. Not only does the Fed’s balance sheet matter as a source of funds, but we believe so does the attractiveness of the recipient of the carry trade – and the trust in its collateral. As Gary Gorton puts it…

 

The output of banks is money, in the form of short-term debt which is used to store value or used as a transaction medium. Such money is backed by a portfolio of bank loans in the case of demand deposits, or by collateral in the form of a specific bond in the case of repo. The backing is designed to make the bank debt as close to riskless as possible — in fact, so close to riskless than nobody wants to really do any due diligence on the money, just transact with it. But the private sector cannot produce riskless debt and so it can happen that the backing collateral is questioned. This typically happens at the peak of the business cycle. If its value is questioned, it loses its “moneyness” so no one wants it, and cash is preferred. But as we know, if everyone wants their cash at the same moment, their demands cannot be satisfied. In this sense, the financial system is insolvent. (interview with the FT) 

 

What makes sense for an individual carry trade – borrow low, invest at higher rates – falls prey to the fallacy of composition, when too many engage in the same carry trade. And eventually question the underlying collateral, now huge, and potentially suspect. China is a case in point. If our colleagues David Cui and Bin Gao are right, the trust sector in Chinacould create rollover risks that reverse a gluttonous carry trade within China, but partly financed overseas. In China’s case, this trade was between low global interest rates, low Chinese deposit rates, expectations of perpetual RMB appreciation on the one hand, and higher investment returns promised by Trusts on the other. A part of the debt funds raised overseas, we suspect were put to work in this Trust carry trade. The HK-based banks are big participants in intermediating the China carry trade – as Chart 12 shows, their net lending to China went from 18% of HK GDP in 2007 to 148% in late-2013.

 

There are always fancy names given to carry trades – financial liberalization of capital accounts, the Bangkok International Banking Facility, currency internationalization, etc. We remain skeptics of these buzzwords.

 

 

 

The potential consequences of Trust defaults and a China carry trade unwind

 

1. If the EM carry trade diminishes as a consequence of a changed Fed policy and/or less attractive risk-adjusted returns in EMs as collateral quality is questioned, the sources of China’s forex reserve accumulation will need to change. Perhaps to bigger current account surpluses, more equity FDI and portfolio investment through privatization and more open equity markets. If that does not happen, expanding the Chinese monetary base might require PBOC to increase net lending to the financial system and/or monetize fiscal deficits (this last part has not worked so well in EMs).

 

2. Potential asset deflation is a risk, as the carry trades diminish/unwind. Property prices are at risk – the collateral value for China’s financial systems. This is not a dire projection – it simply seeks to isolate the US QE as a key driver of China’s monetary policy and asset inflation, and highlights the magnitudes involved, and the transmission mechanism. Investors should not imbue stock-price movements and property price inflation in China with too much local flavor – this is mainly a US QE-driven story, in our view.

 

3. Currently, China’s real effective exchange rate is one of the strongest in the world. Concerns about China’s Trust sector, and its underlying collateral value, sees some of this carry trade unwound, the RMB could be under pressure.

 

 

4. Given HK’s role in the China carry trade, HK property prices and its banking system should be watched carefully for signs of stress.

 

5. UK, US, and Japan banking systems have been active lenders to China since QE. They should be on watch if the Trust rollover risk materializes and creates a growth shock in China. See Chart 15.

 

 

 

6. Safe haven bids for DM government bonds, overseas property and precious metals might emerge from China.

 

Could the party go on? Yes, if for some reason a significant deterioration in the US labor market, or a deflationary shock from China, or any other surprise that could lead to a cessation of the US tapering could prolong this carry trade. This is not the house base case. We believe it is better to start preparing for a post-QE world. As one of our smartest clients told us: “the main theme in the past five years was QE. If that is coming to an end, investments and themes that worked in the past five years must therefore be questioned.” We agree.

* * *

Yes, Bank of America said all of the above – every brutally honest last word of it.

The question, however, in addition to “why”, is whether the Fed also agrees with BofA’s stunningly frank, and quite disturbing conclusion, perhaps finally realizing that aside from the US, the biggest house of cards that would topple once the “flow”-free emperor is exposed in his nudity, is that of the world’s largest “growth” (and credit) dynamo of the past two decades – China.Because, as noted above, if Lehman’s collapse was bad, a deflationary collapse brought on by Chinese hard landing coupled with a full unwind of the global carry trade, would be disastrous and send the world into a depression the likes of which have never before been seen.

Finally, for those who want the blow by blow, here is BofA’s tentative take of what the preliminary steps of the next global great depression will look like:

If we do experience a sizable default, the knee-jerk market reaction will be cash hoarding since it will strike as a big surprise. Thus, we expect the repo rate to rise first, while the long term government bond would get bid due to risk aversion flows.

 

However, what follows will be quite uncertain, aside from PBoC injecting liquidity and easing monetary policy to help short term rate come down. It has been proven again and again the Chinese government will get involved and be proactive. The bond market reaction will be different depending on the government solution.

Alas, at that point, not even the world’s largest bazooka will be enough.

At this point one should conclude that reality – through massive, unprecedented liquidity injections – has been deferred long enough. It is time to let the markets finally return to some semblance ofuncentrally-planned normalcy: there is a reason why nature abhors a vacuum. Even if it means the eruption of the very painful grand reset, washing away decades of capital misallocation, lies and ill-gotten wealth, so very overdue.

Hayek On Keynes: “Economics Was A Sideline For Him” | Zero Hedge

Hayek On Keynes: “Economics Was A Sideline For Him” | Zero Hedge.

Keynes will be remembered as “a man with a great many ideas that knew very little economics,” Friedrich Hayek notes in this brief interview and when challenged on his ‘parochial’ knowledge of economic history he was “not sheepish in the least… he was much too self-assured.” Hayek’s perspective casts Keynes in a very different light than his fan’s apostolic adoration might suggest, “he wasutterly contemptuous of anything that had been done before.” While Hayek describes Keynes as one of the most intelligent people he had known, he perhaps sums up the man’s work in this brief phrase – “economics was just a side-line for him.” As we note below, many describe Keynesian policy as ‘dumb’, however a more appropriate word would be ‘foolish’.

Hayek On Keynes

Keynesian Policies: Not Dumb, Just Foolish (via the Ludwig von Mises Institute of Canada)

A lot of my Austrian friends refer to Keynesian policies as “idiotic,” “stupid,” etc., but that’s not really accurate. Indeed, the Keynesian policy prescriptions are so counterintuitive–they so defy common sense–that only very intelligent people with plenty of schooling could have the confidence to utter them with a straight face.

Rather than describing Keynesian policies as “dumb,” I think a more appropriate word is foolish, because the technical analyses of IS/LM curves, talk of the “liquidity trap” and so on, utterly ignore political realities. A great example of this is Matt Yglesias and his handling of Argentina. Back in May 2012–not that long ago, by any stretch–Yglesias held up Argentina as a model for the eurozone countries. He wrote:

Spain is in a complete economic crisis…But perhaps there is a way out, one suggested by the recent experience of Argentina, a nation that’s currently enjoying full employment. 
…[W]hen the world economy hit a snag in 2001, trouble emerged for Argentina. Unrelated hidden risks were revealed elsewhere in the global investment landscape and everywhere people got nervous. The foreign capital began to abandon Argentina, reducing investment, employment, and incomes. This in turn sharply reduced the Argentine government’s tax revenues and led to calls for sharp budgetary consolidation…Protesters and rioters took to the streets. President Fernando de la Rua’s party took a beating at the polls. Argentina defaulted on its external debt, broke the rigid linkage between the peso and the dollar, and went back to pursuing an independent monetary policy….
Default and devaluation were hardly a party. They destroyed the country’s banking system and wiped out many Argentines’ savings. But it did work. Argentina has grown rapidly in subsequent years and its unemployment rate has fallen steadily…

So Yglesias was recommending that Spain and other troubled countries ditch the euro and default on their sovereign debts, so they could free their printing press from the shackles of Brussels. The obvious Austrian (and generally free-market) response would be to warn that debasing the currency is hardly the path to prosperity, and that “solving” a crisis in this way would merely sow the seeds of a greater problem down the road. The prosperity coming from the printing press was an illusion.

Well, the economy in Argentina is now “melting down”–Yglesias’ own term. But our fearless Keynesian pundit has nothing for which to apologize. He explains in a January 2014 post:

With Argentina’s economy melting down, I’ve gotten various queries from people asking whether I regret having praised the country’s successful 2002 devaluation and default back in 2012 as an example for Spain and Greece to emulate.
The answer is: absolutely not!
Argentina is a country that has not, historically speaking, been well-governed. In fact one reason that the 2002 default was necessary was that Argentina  previously embarked on a deeply misguided currency board scheme. To say that Argentina’s 2002 default and devaluation was the right thing to do and that there are important lessons to be learned from it is not to say that all countries should always emulate Argentina in all respects.

So there you have it, folks: Countries that historically have been ill-governed should follow Argentina’s lead by defaulting on their debts and debasing their currencies, but they should stop right before the bad consequences of these actions come home to roost. Simple as pie. Sort of like giving a bottle of Jack Daniels to some frat guys and sending them to the library to study–what could possibly go wrong?

The Emerging Market Collapse Through The Eyes Of Don Corleone | Zero Hedge

The Emerging Market Collapse Through The Eyes Of Don Corleone | Zero Hedge.

Submitted by Ben Hunt of Epsilon Theory

It Was Barzini All Along

Tattaglia is a pimp. He never could have outfought Santino. But I didn’t know until this day that it was Barzini all along.

— Don Vito Corleone

Like many in the investments business, I am a big fan of the Godfather movies, or at least those that don’t have Sofia Coppola in a supporting role. The strategic crux of the first movie is the realization by Don Corleone at a peace-making meeting of the Five Families that the garden variety gangland war he thought he was fighting with the Tattaglia Family was actually part of an existential war being waged by the nominal head of the Families, Don Barzini. Vito warns his son Michael, who becomes the new head of the Corleone Family, and the two of them plot a strategy of revenge and survival to be put into motion after Vito’s death. The movie concludes with Michael successfully murdering Barzini and his various supporters, a plot arc that depends entirely on Vito’s earlier recognition of the underlying cause of the Tattaglia conflict. Once Vito understood WHY Philip Tattaglia was coming after him, that he was just a stooge for Emilio Barzini, everything changed for the Corleone Family’s strategy.

Now imagine that Don Corleone wasn’t a gangster at all, but was a macro fund portfolio manager or, really, any investor or allocator who views the label of “Emerging Market” as a useful differentiation … maybe not as a separate asset class per se, but as a meaningful way of thinking about one broad set of securities versus another. With the expansion of investment options and liquid securities that reflect this differentiation — from Emerging Market ETF’s to Emerging Market mutual funds — anyone can be a macro investor today, and most of us are to some extent.

You might think that the ease with which anyone can be an Emerging Markets investor today would make the investment behavior around these securities more complex from a game theory perspective as more and more players enter the game, but actually just the opposite is true. The old Emerging Markets investment game had very high informational and institutional barriers to entry, which meant that the players relied heavily on their private information and relatively little on public signals and Common Knowledge. There may be far more players in the new Emerging Markets investment game, but they are essentially one type of player with a very heavy reliance on Common Knowledge and public Narratives. Also, these new players are not (necessarily) retail investors, but are (mostly) institutional investors that see Emerging Markets or sub-classifications of Emerging Markets as an asset class with certain attractive characteristics as part of a broad portfolio. Because these institutional investors have so much money that must be put to work and because their portfolio preference functions are so uniform, there is a very powerful and very predictable game dynamic in play here.

Since the 2008 Crisis the Corleone Family has had a pretty good run with their Emerging Markets investments, and even more importantly Vito believes that he understands WHY those investments have worked. In the words of Olivier Blanchard, Chief Economist for the IMF:

In emerging market countries by contrast, the crisis has not left lasting wounds. Their fiscal and financial positions were typically stronger to start, and adverse effects of the crisis have been more muted. High underlying growth and low interest rates are making fiscal adjustment much easier. Exports have largely recovered, and whatever shortfall in external demand they experienced has typically been made up through an increase in domestic demand. Capital outflows have turned into capital inflows, due to both better growth prospects and higher interest rates than in advanced countries. … The challenge for most emerging countries is quite different from that of advanced countries, namely how to avoid overheating in the face of closing output gaps and higher capital flows. — April 11, 2011

As late as January 23rd of this year, Blanchard wrote that “we forecast that both emerging market and developing economies will sustain strong growth“.

Now we all know what actually happened in 2013. Growth has been disappointing around the world, particularly in Emerging Markets, and most of these local stock and bond markets have been hit really hard. But if you’re Vito Corleone, macro investor extraordinaire, that’s not necessarily a terrible thing. Sure, you don’t like to see any of your investments go down, but Emerging Markets are notably volatile and maybe this is a great buying opportunity across the board. In fact, so long as the core growth STORY is intact, it almost certainly is a buying opportunity.

But then you wake up on July 9th to read in the WSJ that Olivier Blanchard has changed his tune. He now says “It’s clear that these countries [China, Russia, India, Brazil, South Africa] are not going to grow at the same rate as they did before the crisis.” Huh? Or rather, WTF? How did the Chief Economist of the IMF go from predicting “strong growth” to declaring that the party is over and the story has fundamentally changed in six months?

It’s important to point out that Blanchard is not some inconsequential opinion leader, but is one of the most influential economists in the world today. His position at the IMF is a temporary gig from his permanent position as the Robert M. Solow Professor of Economics at MIT, where he has taught since 1983. He also received his Ph.D. in economics from MIT (1977), where his fellow graduate students were Ben Bernanke (1979), Mario Draghi (1976), and Paul Krugman (1977), among other modern-day luminaries; Stanley Fischer, current Governor of the Bank of Israel, was the dissertation advisor for both Blanchard and Bernanke; Mervyn King and Larry Summers (and many, many more) were Blanchard’s contemporaries or colleagues at MIT at one point or another. The centrality of MIT to the core orthodoxy of modern economic theory in general and monetary policy in particular has been well documented by Jon Hilsenrath and others and it’s not a stretch to say that MIT provided a personal bond and a formative intellectual experience for a group of people that by and large rule the world today. Suffice it to say that Blanchard is smack in the middle of that orthodoxy and that group. I’m not saying that anything Blanchard says is amazingly influential in and of itself, certainly not to the degree of a Bernanke or a Draghi (or even a Krugman), but I believe it is highly representative of the shared beliefs and opinions that exist among these enormously influential policy makers and policy advisors. Two years ago the global economic intelligentsia believed that Emerging Markets had emerged from the 2008 crisis essentially unscathed, but today they believe that EM growth rates are permanently diminished from pre-crisis levels. That’s a big deal, and anyone who invests or allocates to “Emerging Markets” as a differentiated group of securities had better take notice.

Here’s what I think happened.

First, an error pattern has emerged over the past few years from global growth data and IMF prediction models that forced a re-evaluation of those models and the prevailing Narrative of “unscathed” Emerging Markets. Below is a chart showing actual Emerging Market growth rates for each year listed, as well as the IMF prediction at the mid-year mark within that year and the mid-year mark within the prior year (generating an 18-month forward estimate).

Pre-crisis the IMF systematically under-estimated growth in Emerging Markets. Post-crisis the IMF has systematically over-estimated growth in Emerging Markets. Now to be sure, this IMF over-estimation of growth exists for Developed Markets, too, but between the EuroZone sovereign debt crisis and the US fiscal cliff drama there’s a “reason” for the unexpected weakness in Developed Markets. There’s no obvious reason for the persistent Emerging Market weakness given the party line that “whatever shortfall in external demand they experienced has typically been made up through an increase in domestic demand.” Trust me, IMF economists know full well that their models under-estimated EM growth pre-crisis and have now flipped their bias to over-estimate growth today. Nothing freaks out a statistician more than this sort of flipped sign. It means that a set of historical correlations has “gone perverse” by remaining predictive, but in the opposite manner that it used to be predictive. This should never happen if your underlying theory of how the world works is correct. So now the IMF (and every other mainstream macroeconomic analysis effort in the world) has a big problem. They know that their models are perversely over-estimating growth, which given the current projections means that we’re probably looking at three straight years of sub-5% growth in Emerging Markets (!!) more than three years after the 2008 crisis ended, and — worse — they have no plausible explanation for what’s going on.

Fortunately for all concerned, a Narrative of Central Bank Omnipotence has emerged over the past nine months, where it has become Common Knowledge that US monetary policy is responsible for everything that happens in global markets, for good and for ill (see “How Gold Lost Its Luster”). This Narrative is incredibly useful to the Olivier Blanchard’s of the world, as it provides a STORY for why their prediction models have collapsed. And maybe it really does rescue their models. I have no idea. All I’m saying is that whether the Narrative is “true” or not, it will be adopted and proselytized by those whose interests — bureaucratic, economic, political, etc. — are served by that Narrative. That’s not evil, it’s just human nature.

Nor is the usefulness of the Narrative of Central Bank Omnipotence limited to IMF economists. To listen to Emerging Market central bankers at Jackson Hole two weeks ago or to Emerging Market politicians at the G-20 meeting last week you would think that a great revelation had been delivered from on high. Agustin Carstens, Mexico’s equivalent to Ben Bernanke, gave a speech on the “massive carry trade strategies” caused by ZIRP and pleaded for more Fed sensitivity to their capital flow risks. Interesting how the Fed is to blame now that the cash is flowing out, but it was Mexico’s wonderful growth profile to credit when the cash was flowing in. South Africa’s finance minister, Pravin Gordhan, gave an interview to the FT from Jackson Hole where he bemoaned the “inability to find coherent and cohesive responses across the globe to ensure that we reduce the volatility in currencies in particular, but also in sentiment” now that the Fed is talking about a Taper. Christine Lagarde got into the act, of course, calling on the world to build “further lines of defense” even as she noted that the IMF would (gulp) have to stand in the breach as the Fed left the field. To paraphrase Job: the Fed gave, and the Fed hath taken away; blessed be the name of the Fed.

The problem, though, is that once you embrace the Narrative of Central Bank Omnipotence to “explain” recent events, you can’t compartmentalize it there. If the pattern of post-crisis Emerging Market growth rates is largely explained by US monetary accommodation or lack thereof … well, the same must be true for pre-crisis Emerging Market growth rates. The inexorable conclusion is that Emerging Market growth rates are a function of Developed Market central bank liquidity measures and monetary policy, and that all Emerging Markets are, to one degree or another, Greece-like in their creation of unsustainable growth rates on the back of 20 years of The Great Moderation (as Bernanke referred to the decline in macroeconomic volatility from accommodative monetary policy) and the last 4 years of ZIRP. It was Barzini all along!

This shift in the Narrative around Emerging Markets — that the Fed is the “true” engine of global growth — is a new thing. As evidence of its novelty, I would point you to another bastion of modern economic orthodoxy, the National Bureau of Economic Research (NBER), in particular their repository of working papers. Pretty much every US economist of note in the past 40 years has published an NBER working paper, and I only say “pretty much every” because I want to be careful; my real estimate is that there are zero mainstream US economists who don’t have a working paper here.

If you search the NBER working paper database for “emerging market crises”, you see 16 papers. Again, the author list reads like a who’s who of famous economists: Martin Feldstein, Jeffrey Sachs, Rudi Dornbusch, Fredric Mishkin, Barry Eichengreen, Nouriel Roubini, etc. Of these 16 papers, only 2 — Frankel and Roubini (2001) and Arellano and Mendoza (2002) — even mention the words “Federal Reserve” in the context of an analysis of these crises, and in both cases the primary point is that some Emerging Market crises, like the 1998 Russian default, force the Fed to cut interest rates. They see a causal relationship here, but in the opposite direction of today’s Narrative! Now to be fair, several of the papers point to rising Developed Market interest rates as a “shock” or contributing factor to Emerging Market crises, and Eichengreen and Rose (1998) make this their central claim. But even here the argument is that “a one percent increase in Northern interest rates is associated with an increase in the probability of Southern banking crises of around three percent” … not exactly an earth-shattering causal relationship. More fundamentally, none of these authors ever raise the possibility that low Developed Market interest rates are the core engine of Emerging Market growth rates. It’s just not even contemplated as an explanation.

Today, though, this new Narrative is everywhere. It pervades both the popular media and the academic “media”, such as the prominent Jackson Hole paper by Helene Rey of the London Business School, where the nutshell argument is that global financial cycles are creatures of Fed policy … period, end of story. Not only is every other country just along for the ride, but Emerging Markets are kidding themselves if they think that their plight matters one whit to the US and the Fed.

Market participants today see Barzini/Bernanke everywhere, behind every news announcement and every market tick. They may be right. They may be reading the situation as smartly as Vito Corleone did. I doubt it, but it really doesn’t matter. Whether or not I privately believe that Barzini/Bernanke is behind everything that happens in the world, I am constantly told that this is WHY market events happen the way they do. And because I know that everyone else is seeing the same media explanations of WHY that I am seeing … because I know that everyone else is going through the same tortured decision process that I’m going through … because I know that everyone else is thinking about me in the same way that I am thinking about them … because I know that if everyone else acts as if he or she believes the Narrative then I should act as if I believe the Narrative … then the only rational conclusion is that I should act as if I believe it. That’s the Common Knowledge game in action. This is what people mean when they say that a market behavior of any sort “takes on a life of its own.”

For the short term, at least, the smart play is probably just to go along with the Barzini/Bernanke Narrative, just like the Corleone family went along with the idea that Barzini was running them out of New York (and yes, I understand that at this point I’m probably taking this Godfather analogy too far). By going along I mean thinking of the current market dynamic in terms of risk management, understanding that the overall information structure of this market is remarkably unstable. Risk-On / Risk-Off behavior is likely to increase significantly in the months ahead, and there’s really no predicting when Bernanke will open his mouth or what he’ll say, or who will be appointed to take his place, or what he or she will say. It’s hard to justify any large exposure to public securities in this environment, long or short, because all public securities will be dominated by this Narrative so long as everyone thinks that everyone thinks they will be dominated. This the sort of game can go on for a long time, particularly when the Narrative serves the interests of incredibly powerful institutions around the world.

But what ultimately saved the Corleone family wasn’t just the observation of Barzini’s underlying causal influence, it was the strategy that adjusted to the new reality of WHY. What’s necessary here is not just a gnashing of teeth or tsk-tsk’ing about how awful it is that monetary policy has achieved such behavioral dominance over markets, but a recognition that it IS, that there are investment opportunities created by its existence, and that the greatest danger is to continue on as if nothing has changed.

I believe that there are two important investment implications that stem from this sea change in the Narrative around Emerging Markets, which I’ll introduce today and develop at length in subsequent notes.

First, I think it’s necessary for active investors to recalibrate their analysis towards individual securities that happen to be found in Emerging Markets, not aggregations of securities with an “Emerging Markets” label. I say this because in the aggregate, Emerging Market securities (ETF’s, broad-based funds, etc.) are now the equivalent of a growth stock with a broken story, and that’s a very difficult row to hoe. Take note, though, the language you will have to speak in this analytic recalibration of Emerging Market securities is Value, not Growth, and the critical attribute of a successful investment will have little to do with the security’s inherent qualities (particularly growth qualities) but a great deal to do with whether a critical mass of Value-speaking investors take an interest in the security.

Second, there’s a Big Trade here related to the predictable behaviors and preference functions of the giant institutional investors or advisors that — by size and by strategy — are locked into a perception of Emerging Market meaning that can only be expressed through aggregations of securities or related fungible asset classes (foreign exchange and commodities). These mega-allocators do not “see” Emerging Markets as an opportunity set of individual securities, but as an asset class with useful diversification qualities within an overall portfolio. So long as market behaviors around Emerging Markets in the aggregate are driven by the Barzini/Bernanke Narrative, that diversification quality will decline, as the same Fed-speak engine is driving behaviors in both Emerging Markets and Developed Markets. Mega-allocators care more about diversification and correlations than they do about price, which means that the selling pressure will continue/increase so long as the old models aren’t working and the Barzini/Bernanke Narrative diminishes what made Emerging Markets as an asset class useful to these institutions in the first place. But when that selling pressure dissipates — either because the Barzini/Bernanke Narrative wanes or the mega-portfolios are balanced for the new correlation models that take the Barzini/Bernanke market effect into account — that’s when Emerging Market securities in the aggregate will work again. You will never identify that turning point in Emerging Market security prices by staring at a price chart. To use a poker analogy you must play the player — in this case the mega-allocators who care a lot about correlation and little about price — not the cards in order to know when to place a big bet.

In future weeks I’ll be expanding on each of these investment themes, as well as taking them into the realm of foreign exchange and commodities. Also, there’s a lot still to be said about Fed communication policy and the Frankenstein’s Monster it has become. I hope you will join me for the journey, and if you’d like to be on the direct distribution list for these free weekly notes please sign up at Follow Epsilon Theory.

“Two Roads Diverged” – Wall Street’s Doubts Summarized As “The Liquidity Tide Recedes” | Zero Hedge

“Two Roads Diverged” – Wall Street’s Doubts Summarized As “The Liquidity Tide Recedes” | Zero Hedge.

From Russ Certo, head of rates at Brean Capital

Two Roads Diverged

As we know, it has been a suspect week with a variety of earnings misses.  Although I have been constructive on risk asset markets generally, equities anecdotally, as figured year end push for alpha desires could let it run into year end.  New year and ball game can change quickly.  Just wondering if a larger rotation is in order.

There is an overall considerable theme of what you may find when a liquidity tide recedes as most major crises or risk pullbacks have been precipitated by either combination of tighter monetary or fiscal policy.  Some with a considerable lag like a year after Greenspan departed from Fed helm, or many other examples.  I’m not suggesting NOW is a time for a compression in risk but am aware of the possibility, especially when Fed Chairs take victory laps, Bernanke this week.  Symbolic if nothing more.       Cover of TIME magazine?

I happen to think that 2014 is a VERY different year than 2013 from a variety of viewpoints.  First, there appears to be a dispersion of opinion about markets, valuations, policy frameworks and more. This is a healthy departure from YEARS of artificiality.  Artificiality in valuations, artificiality in market and policy mechanics and essentially artificiality in EVERY financial, and real, relationship on the planet based on central bank(s) balance sheet expansion and other measures intended to be a stop-gap resolution to  tightening financial conditions, adverse expectations of economic activity, and the great rollover….of both financial and non-financial debt financing.       Boy, what a week in the IG issuance space with over $100 billion month to date, maybe $35 billion on the week.        Debt rollover on steroids.

Beneath the veneer of market aesthetics, I already see fundamental (and technical) relevance.  This could be construed as an optimist pursuit or reality that markets are incrementally transcending reliance and/or dependence on the wings of central bank policy prerogatives.  The market bird is trying to fly on its own with inklings of a return to FUNDAMENTAL analysis.  A good thing, conceptually, and gradualist development of passing the valuation baton back to market runners.  A likely major pillar objective of policy despite more than a few critics worried about seemingly dormant lurking imbalances created by immeasurable policy and monetary and fundamentally skewed risk asset relationships globally.

This exercise of summarization of ebb and flow and comings and goings of markets and policy naturally funnels a discussion to what stature of central bank policy currently or accurately exists?  Current events.  What is the accurate stage of policy?

I actually think this is a more delicate nuance than I perceive viewed in overall market sentiment. Granted, we have taken a major step for mankind, which is the topical engagement of some level of scope or reduction of liquidity provisioning,” not tightening.”  Tip of the iceberg communique with markets to INTRODUCE the concept of stepping off the gas but not hitting the break.  Reeks of fragility to me but narrative headed in right direction to stop medicating the patient, the global economy.

Some markets have logically responded in kind.  The highest beta markets as either beneficiaries or vulnerable to monetary policy changes, the emerging markets, have reflected at least the optics of change with policy.  More auditory than optics in hearing a PROSPECTIVE change in garbled Fedspeak.  The high flyer currencies which capture the nominal flighty hot money flows globally affirmed the Fed message.

In literally the simplest of terms, the G7 industrialized, not peripheral; interest rate complex has simply moved the needle in form of +110 basis point higher moves in nominal sovereign interest rates.  And there are a bevy of other expressions which played nicely and rightly conformed to the messages coming out of the central bank sandbox.  But there are ALSO notable dichotomies, which send a different or even the opposite message.

I perceive a deviation in perception of message as some markets or market participants appear to be betting on taper or a return to normalcy in global growth or U.S. growth outcomes???  OR no taper, or conversely QE4 or whatever.  Sovereign spreads have moved materially tighter vs. industrial and supposed risk free rates (Tsys, Gilts, Bunds) both last year and in the first three weeks of 2014. Something a new leg of QE would represent, not a taper.   A different year!!!

There have been VERY reliable risk asset market beta correlations over the last 5 years and sovereign or peripheral spreads have been AS volatile and correlated as any asset class.  These things trade like dancing with a rattle-snake.  Greece, Spain, France etc.  They can bite you with fangs.  They have been meaningfully more correlated to high yield spreads and yields and to central bank balance sheet expansion as nearly any asset class.  So, the infusion of central bank liquidity into markets has seen “relief” rallies in peripherals and one would think the converse would be true as well.  The valuations have represented the flavor and direction of risk on/risk off or liquidity on/liquidity off reliably for many months/years.

But I THOUGHT markets were deliberating tapering views and expressions as validated by some good soldier markets BUT that is not necessarily what the rally in riskiest of sovereign “credits” is suggesting.  The complex seems to be decoupling with Fed balance sheet correlation and message.  Some are OVER 100 standard deviations from the mean!  They are rich and could/should be sold.     Especially if one was to follow the obvious correlation with the direction of central bank as stated.

But look to other arena’s like TIPS breakevens which also have been correlated with liquidity and risk on/off and central bank balance sheet expansion.  Correlated to NASDAQ, HY, peripherals and the like.   BUT this complex COUNTERS what peripherals are doing.  They haven’t shown up to the punch bowl party yet.  Not invited.      This is a departure of markets that have largely and generally been in synch from a liquidity and performance correlation view.

Like gold and silver which got tattooed vis a vis down 35%+ performance last year MOSTLY, but not exclusively, due to perceptions of winds of central bank change.  BUT even within a contrary, the fact that rallies in Spain, France, Greece, and Italy reflect more of central bank easing notions, the opposite of taper.  In essence, the complex has gone batty uber-appreciation this year.  Sure, many eyeball the Launchpad physical metals marginal stabilization no longer falling on a knife but the miner bonds and the mining stocks are string like bull with significant appreciation.  This decidedly isn’t the stuff of taper which had the bond daddy’s romancing notions of 3% 10yr breaks, 40 basis point Green Eurodollar sell-offs,  emerging market rinse, and upticks in volatility amongst other things.

Equity bourses appear to be changing hands between investors with oscillating rotations which mark the first prospective 3 week consecutive sell-off in a while.  New year.  This is taper light.       Somewhere in between and further blurs the correlation metrics.

So, which is it?  Are we tapering or not and why are merely a few global asset classed pointed out here, why are they deviating or arguably pricing in different central bank prospects or scenarios or outcomes?

I’m not afraid but I am intrigued as to the fact that there may some strong opinions within markets and I perceive a widely received comfortability with taper or tightening notions, negative leanings on interest rate forecasts, a complacency of Fed call if you will.  And all of these hingings occur without intimate knowledge of the most critical variable of all, what Janet Yellen thinks? She has been awfully quiet as of late and there are many foregone conclusions or assumptions in market psyche without having heard a peep from the new MAESTRO.

Moreover, looking in the REAR view mirror within a week where multiple (two) Fed Governor proclamations, communicated and implicated notions which arguably would be considered radical in ANY other policy period of a hundred years.  How to conduct “monetary policy at a ZERO lower bound (Williams) ” and “doing something as surprising and drastic as cutting interest on excess reserves BELOW zero (Kocherlakota).”

This doesn’t sound like no stinking taper?  A tale of two markets.  To be or not to be.  To taper or not to taper.  Two roads diverged and I took the one less traveled by, and that has made all the difference.  Robert Frost.

Which is it? Different markets pricing different things.  Right or wrong, the market always has a message; listen critically.

Russ

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