Saturday, August 1, 2009

Bubble Analysis

Doug Noland of Prudent Bear is a man of great wisdom and insight. He gathers information like a squirrel, dissects it and puts his conclusion down in a very readable format.

Today he writes about bubbles, that any bubble is the cause of loose credit politics and when the bubble appears, it re-enforces itself and is destructive in the end. He argues that:
"an unlimited supply of Credit will tend to satisfy rising demand at a lower price",
followed by the statement that:
"today’s mispricing of government finance feeds reinforces the market’s perception that U.S. policymakers will successfully reflate the economy. This Bubble distortion, then, fosters a problematic explosion of government debt issuance – and a most dangerous case Minskian “Ponzi finance.”
He sees both the Chinese and the Fed being held hostage by bubble dynamics and does not see any willingness from policymakers to act decisively against increasingly speculative financial markets.

Great insight.

Facets of Bubble Analysis:

The Prudent Bear; Credit Bubble Bulletin

...... A couple years back I received an email from a unimpressed reader with the following message: “Doug, when you’re a hammer everything looks like a nail.” He was referring to my thesis back then that Bubbles had sprung loose from the U.S. Credit system and had begun propagating around the world.

Months back I posited that a Government Finance Bubble had emerged from the smoking ashes of the Wall Street/mortgage finance Bubble. I understand why some might see me as a dreary hammer out searching for nails. All the same, the backdrop merits further discussion of facets of Bubble analysis.

Many see Bubbles in terms of an unsustainable overvaluation of asset prices. And many would view today’s “post-Bubble” landscape and find my ongoing Bubble premise borderline ridiculous. But I’ve always viewed Bubbles as a Credit phenomenon. Inflating assets prices are actually only one of many consequences of an over expansion of Credit. Rapid asset inflation is almost a sure sign of underlying Credit excess, though analysts should downplay asset prices while focusing keenly on underlying Credit and speculative dynamics. Huge Credit growth, market price distortions (especially the under-pricing of risk), highly speculative markets, and prolonged asset inflation are inevitably indicative of some underlying monetary/Credit disorder.

I want policymakers out of the business of targeting or tinkering with the asset markets and market yields. Instead, the focus should be on creating a backdrop of stable money and Credit. The problem today is that central bankers for years ignored a historic expansion of Credit (much of it directed to the asset markets) and resulting Monetary Disorder. Now, to avert systemic implosion central bankers at home and abroad have resorted to unprecedented measures to expand Credit and intervene in the market's pricing of Credit. Instead of a movement toward constructing a more stable global Credit system and backdrop, policymakers have instead jumped farther into the uncharted waters of unconstrained Credit expansion. Such a backdrop is ultra-conducive for ongoing speculation, Bubbles, general disorder.

Again, Bubbles are first and foremost a Credit phenomenon. Fundamental to the nature of Credit, expansion generally fosters more expansion. Credit excess begets only greater Credit excess. And Credit excess notoriously begets speculative excesses. Importantly, Credit is inherently self-reinforcing – both on the upswing and downswing. In today’s “system” of unrestrained Credit, rising demand does not dictate an increasing price for this Credit. Indeed, an unlimited supply of Credit will tend to satisfy rising demand at a lower price. And this gets right to the heart of a huge Bubble – and policymaking - dilemma.

The bottom line is that unrestrained Credit is inherently unstable, and few seem to appreciate the unique nature of today’s unfettered global Credit environment. There is no international gold monetary regime for which to discipline lenders, central banks, governments or economies. The dollar reserve system self-destructed over decades of undisciplined Credit expansion. And the breakdown of U.S. discipline – and the resulting massive dollar devaluation – has unleashed domestic Credit systems from China to Brazil. Never have “developing” Credit systems (and currencies) enjoyed such freedom to inflate financial claims.

It’s with this backdrop in mind that I contemplate the likelihood that we have entered an especially dangerous period of Credit excess and attendant Bubbles. Fundamentally, the massive intrusion of the Treasury and Federal Reserve into the marketplace has only further distorted the pricing of finance throughout our economy - as well as globally. Despite record debt issuance, the market will lend the Treasury three-month money at about 11 basis points. Two-year borrowings come at cost of about 100 bps. The price of Treasury notes and bonds inflates in spite of enormous deficits as far as the eye can see. Moreover, the marketplace is happy to lend to Fannie and Freddie at only a slight premium to the U.S. Treasury, with the prices of their obligations inflating in the face of these institutions’ ongoing financial implosions. Today’s price distortions go right to the heart of system “money.

Fannie Mae’s Book of Business (mortgage holdings and MBS guaranteed) jumped $43.9bn during June to $3.194 TN. This was the biggest growth since December 2007. Freddie’s Book of Business increased $12.2bn last month. According to Bloomberg’s issuance tally, the GSEs (Fannie, Freddie and Ginnie) issued $168bn of MBS in July, down somewhat from June’s huge $236bn and May’s $212bn. At $1.102 Trillion, year-to-date agency MBS issuance has already almost matched 2008 and 2007. The government is quietly accumulating dangerous Credit and interest rate risk in its ongoing mortgage operations.

During the Wall Street/mortgage finance Bubble, seemingly no amount of Credit creation and debt issuance would place upward pressure on the cost of borrowings (or reduced the price of the underlying debt instruments). Importantly, the bigger this Bubble inflated the more confident the savvy market operators became that an inevitable crisis would force policymakers to explicitly back GSE obligations and aggressively slash interest rates. Market yields remained artificially low and increasingly detached from escalating risks. Fundamentally, a market trapped in Bubble dynamics had lost is capacity for adjustment and self-regulation.
The massive expansion of GSE obligations, coupled with a speculative marketplace’s anticipation of yet another major government-induced reflation, severely distorted the marketplace and provided the bedrock for a historic mortgage finance Bubble. Today, the government’s intrusion into the marketplace is greater than ever. The markets readily accommodate a couple Trillion of annual issuance – as if the U.S. economy and Credit system were on solid footing. And I would argue that today’s mispricing of government finance feeds reinforces the market’s perception that U.S. policymakers will successfully reflate the economy. This Bubble distortion, then, fosters a problematic explosion of government debt issuance – and a most dangerous case Minskian “Ponzi finance.”

There are a number of reasons why the government finance Bubble is even more dangerous than the Wall Street/mortgage finance Bubble. First of all, the $2 TN or so of “government” issuance over the past year is greater than the $1.4 TN of peak total mortgage Credit growth during 2005 and 2006. I would expect another $2 TN next year and the year after. Government debt enjoys the attribute of “moneyness” in the marketplace to a much greater capacity than mortgage securities did during the boom. The risks associated with debasing this “moneyness” are momentous. And there is, as well, the dynamic where the greater the government finance Bubble inflates the more convinced the marketplace becomes that the Federal Reserve will do everything within its power to accommodate the debt markets (ultra-loose monetary conditions for the duration). And destabilizing speculation can return to all markets…

The government finance Bubble is a global dynamic. There were pertinent Bubble-related comments out of China this week:

July 30 – Dow Jones (J.R. Wu): “China’s central bank will emphasize market-based systems, rather than administrative controls, in guiding the appropriate growth of credit, People’s Bank of China Vice Governor Su Ning said. The statement… came just hours after Chinese shares posted their biggest one-day percentage fall in over eight months on fears that loan growth may start to pull back… ‘We should pay attention to the use of market-oriented means - rather than controlling the size - and flexibly use various monetary policy tools to guide the appropriate growth of credit,’ Su said… He said ‘the mind and action’ of all financial institutions should ‘be as one’ with the government’s goal, and financial institutions should properly handle the relationship between supporting the economy’s development and preventing financial risks. Su’s comments appeared to signal the PBOC wasn’t about to set loan curbs in the second half of this year to cool explosive lending growth, as it did in 2008 when it used the blunt tool of loan quotas for banks to hold down inflationary pressures that were building at the time… But Su said the central bank will resolutely maintain its moderately loose monetary policy. He said the foundation for China’s economic recovery isn’t firm yet and many uncertain factors still exist in both the external and domestic environment.”

Similar to the Federal Reserve, I see Chinese authorities increasingly held hostage to Bubble Dynamics. I found it fascinating that a top People’s Bank of China official would mention emphasizing “market-based systems” for guiding Credit growth. I suspect this may be a most inopportune time to begin relying on market mechanisms. As we have witnessed, market-based processes can be particularly unreliable Credit regulators after Bubbles reach an overheated state. It is my view that only decisive action by Chinese policymakers will at this point have much impact at restraining excess. Central to the analysis of unfolding precarious Bubble Dynamics is my view that few, if any, policymakers anywhere around world will be willing to act decisively to tighten Credit conditions and address increasingly speculative financial markets.

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