Things have been a little erratic lately here in US, but not really headline-worthy. The economy continues to grow, sort of, houses continue to sell and stock and bond prices fluctuate but can’t seem to follow through in either direction. We are not, in short, engulfed in any kind of crisis.
But out in the world, especially in once-hot emerging markets like Brazil and China, the story is very different. As Prudent Bear’s Doug Noland explains in his most recent Credit Bubble Bulletin:
Meanwhile, the “developing” market Bubble continues to unwind. As leverage comes out of the commodities, currency “carry trades” and developing stocks and bonds. And as capital flight becomes a more serious issue, the marketplace must ponder the consequences not only of what a faltering Bubble means for scores of markets and economies, there is as well the issue of developing central banks having to sell from their trove of Treasuries and bunds and such to finance a surge in outflows (“hot” and otherwise). There’s even this new dynamic where Treasury yields rise on days of global currency and equity market tumult. It’s been awhile…
I suspect that the global jump in yields (and CDS and risk premiums) has more to do with de-leveraging than it does with tapering worries. This dynamic has caught many by surprise. The speculators anticipated cleverly exiting their leveraged MBS and other trades based on their expectations for Fed policy. Now, there’s a tremendous amount of unanticipated market uncertainty.
Japanese policymakers have really mucked things up. The Nikkei sank 6.5% Thursday and was down 1.5% for the week. Perhaps it’s a little early to pronounce the BOJ’s “shock and awe” monetary experiment a failure. The yen rallied 3.5% this week against the dollar. Against the Philippine peso it was up 4.5%, versus the South Korean won 4.1%, the Indian ruppee 4.3%, the Malaysian ringgit 4.0%, the Indonesian rupiah 3.2%, the Argentine peso 3.9% and the Brazilian real 4.2%. Indonesia raised rates to support its weak currency. The yen “carry trade” (sell yen and use proceeds to buy higher-yielding instruments globally) is doling out painful losses – forcing the unwind of leveraged trades across many markets. I wouldn’t be surprised if the yen short is the largest short position in modern history. The yen bears are now running for cover – causing all kinds of havoc in the currencies and securities markets.
“Emerging” Asian markets are in the middle of an unfolding financial storm. Friday’s 2.1% gain cut the Philippine equities loss for the week to 9.2%. Even with Friday’s 4.4% recovery, the Thailand stock exchange ended the week down 3.4%. South Korea’s Kospi dropped another 1.8%.
Latin America is as well caught in troubling dynamics. Brazil’s currency (real) traded to a four-year low against the dollar this week – despite currency interventions and the removal of taxes on financial flows and currency derivatives. Brazilian equities were hit for 4.4% this week, increasing y-t-d losses to 19.1%. Mexican stocks dropped 2.4%, boosting y-t-d losses to 10.2%.
The Shanghai composite dropped 2.2% in a holiday-shortened week. China pegs its currency to the U.S. dollar, so we can’t look to the performance of the renminbi for much of an indication of flows or mounting financial market stress.
I have posited that China is in the midst of an historic Credit Bubble. I have over the years tried to explain how interrelated their Bubble is to ours. Our mismanagement of the world’s reserve currency led to 20 years of huge Current Account Deficits. A significant portion of the Trillions of associated IOU’s have made it onto the balance sheet of the People’s Bank of China, especially over recent years. And no Credit system and economy has gone to greater excess during the post-2008 global reflation. It was the “fledgling” Credit Bubble spurred to “terminal phase” excess.
If the “developing” economy Bubble has passed an important inflection point, then China is vulnerable. If “hot money” is leaving EM [emerging markets] then China should be susceptible. And, let there be no doubt, when China finally succumbs global economic prospects really dim – and prospects for some fellow EM economies turn downright dismal. Recall how the tightening of subprime finance gravitated to “Alt-A” and then worked its way to the “conventional” core. And when housing in general began to falter the bottom fell out of subprime.
This week provided a bevy of notable China-related headlines: From the Financial Times: “China Debt Auction Failure Raises Liquidity Fears;” “Fresh Data Highlight China’s Sluggish Growth.” From Bloomberg: “China Debt Sale Fails for First Time in 23 Months on Cash Crunch;” “China Local Debt Audit ‘Credit Negative,’ Moody’s Says;” “China’s Leaders Face Test of Growth Resolve After May Slowdown;” “China Export Growth Plummets Amid Fake-Shipment Crackdown.” From Reuters: “Fitch Warns on Risks from Shadow Banking in China;” “China Estimates Fake Trade Invoicing at $75 billion in Jan-April;” “China State Auditor Warns Over Local Government Debt Levels.”
The price of Chinese sovereign Credit default swap (CDS) “insurance” jumped from 92 to 113 in three sessions, before dropping back down to 98 on Friday. Chinese interbank lending rates have recently spiked higher – and there were even reports of several borrowers forced to pay up for increasingly scarce liquidity. There were debt auctions that did not go smoothly. The currency forwards market is showing some atypical downward pressure on the renminbi.
Many believe this newfound tightness in Chinese money markets can be easily resolved by liquidity injections from the People’s Bank of China. And perhaps Chinese monetary and economic managers still have things under control. If so, the same clearly cannot be said for many of their fellow “developing” policymakers. Capital flight is always extremely difficult to manage. I worry that the world has never faced the possibility for such destabilizing flows and speculative de-leveraging. To be sure, global markets have never been as dependent upon the power of central bankers. And in my mental tallies of risk and complacency, I never envisaged they could so elevate in tandem.
So can the US stay placid when the rest of the world turns chaotic? Highly doubtful. There’s a market phenomenon in which one investment play blows up and forces those on the wrong side of the trade to dump their liquid assets to raise cash — which causes the high-quality assets to fall as much or more than the junk. As Noland notes, the world’s premier liquid asset is the Treasury bond.
If the developing world’s need to raise cash is a factor in the recent spike in US interest rates, this implies a feedback loop in which rising US rates further destabilize emerging markets, forcing the sale of more Treasuries, and so on. Can the Fed stop this? Not unless it wants to buy up not just all the newly-issued Treasuries as it does now, but the trillions of dollars of bonds that might be dumped once things really get going.
It’s important to understand that we’re here because for years the developed world in general and the US in particular have been exporting their problems to the developing world via monetary policy. We fund our overspending by creating a bunch of new dollars, many of which flow beyond our borders looking for higher yields. They land in, say, Brazil, pushing up both local asset prices and the exchange rate of the real. So individual Brazilians see their cost of living rise while Brazilian exporters are priced out of global markets. This is the currency war that Brazil’s government has been complaining about.
Then the hot money flows back out, causing a different set of problems for a country that has spent the past decade trying to adjust to excessive capital inflows. The result: some seriously fragile banks and over-leveraged companies and investors, any of which could trigger a nationwide crisis.
The same general process is at work in other major emerging markets, with each in its own way now posing a threat to the global financial system — at the pinnacle of which sit the S&P 500 and the Treasury market, looking an awful lot like Southern California real estate circa 2007.