Latent Fragilities

Doug Nolan

I have a rather simple Bubble definition: "A self-reinforcing but inevitably unsustainable inflation." Most Bubble discussions centers on the deflating rather than the inflating phase. A focus of my analysis is the progressively powerful dynamics that fuel Bubble excess, along with attendant distortions and maladjustment - and how they sow the seeds of their own destruction.

The ongoing "global government finance Bubble" is unique in history. Rarely has market intervention and manipulation been so widely championed. Never have governments and central banks on a concerted basis inflated government debt and central bank Credit. And almost a full decade since the crisis, the massive inflation of "money"-like government obligations runs unabated - across the continents.

The IMF calculated first quarter real global GDP growth at 3.64%, near the strongest expansion since 2011. U.S. Q2 GDP of 4.1% was the strongest since Q3 2014. There have been only eight stronger quarters of U.S. growth over the past 18 years.

Extreme and protracted policy (fiscal and monetary) stimulus has indeed stimulated real economy expansion. Given sufficient scope and duration, stimulus will invariably fuel spending and investment. Unfortunately, however, the artificial boom is not without myriad negative consequences. Is the boom sustainable? Have we today reached the point where economic growth is self-supporting? Or, instead, is the global boom vulnerable to the curtailment of aggressive stimulus? Has global government stimulus promoted a return to stability? Or has almost a decade of unprecedented measures only exacerbated Latent Fragilities?

It was yet another week that seemed to support the Acute Latent Fragility Thesis.

July 22 - Financial Times (Gabriel Wildau and James Kynge): "China's central bank injected Rmb502bn ($74bn) into its banking system on Monday to help fortify a weakening domestic economy against the impact of an escalating trade war with the US and growing friction with Washington over its falling currency. The injection was the most emphatic move in a series of recent indications that Beijing is moving to ease monetary policy… Raising the risk that the US-China trade war could turn into a currency war, Mr Trump has accused Beijing of manipulating the renminbi, which last Friday reached its lowest point for a year against the US dollar. It has fallen 5% since the start of last month."

Despite GDP growth in the neighborhood of 6.0%, booming household borrowings, an unrelenting apartment Bubble and an ongoing Credit boom, China has once again been compelled to resort to aggressive stimulus in an attempt to hold its tottering Bubble upright. The Chinese economy's vulnerability to a U.S. trade war is generally offered as the impetus behind recently announced measures. Perhaps exposure to the faltering EM Bubble is also a pressing concern in Beijing.

July 22 - Wall Street Journal (Jeremy Page and Saeed Shah): "Pakistan's first metro, the Orange Line, was meant to be an early triumph in China's quest to supplant U.S. influence here and redraw the world's geopolitical map. Financed and built by Chinese state-run companies, the soon-to-be-finished overhead railway through Lahore is among the first projects in China's $62 billion plan for Pakistan. Beijing hoped the $2 billion air-conditioned metro, sweeping past crumbling relics of Mughal and British imperial rule, would help make Pakistan a showcase for its global infrastructure-building spree. Instead, it has become emblematic of the troubles that are throwing China's modern-day Silk Road initiative off course. Three years into China's program here, Pakistan is heading for a debt crisis, caused in part by a surge in Chinese loans and imports for projects like the Orange Line, which Pakistani officials say will require public subsidies to operate."

A few decades ago it was Japanese Bubble Finance spreading its tentacles around the world. This week saw Japanese 10-year yields almost reach 11 bps, near the high going back to January 2016. It took two Bank of Japan (BOJ) interventions - offers to buy unlimited JGBs - to push yields back below 10 bps by Friday. There is considerable market focus on next week's BOJ policy meeting, along with heightened concerns in Japan for the sustainability of the BOJ's policy course. Holding "market" yields indefinitely at zero promotes distortions and imbalances. Various reports have the BOJ contemplating adjusting this policy. The BOJ may also adjust its ETF purchase program viewed as distorting the Japanese equities market.

Sharing a similar experience to central bankers around the globe, the BOJ has seen the impact of its inflationary policies much more in booming securities markets rather than from (stagnant) aggregate price levels in the real economy. Despite a massive expansion of central bank Credit, Japanese core consumer price inflation is expected this year to be about half the bank's 2.0% policy target. Increasingly, the 1% difference in CPI must seem secondary to risks mounting in the financial markets.

July 26 - Bloomberg (Masaki Kondo and Chikafumi Hodo): "For all the speculation over possible Bank of Japan policy tweaks next week, the most important change for global bond markets may already be underway. While market watchers disagree about whether the BOJ will adjust its target of keeping 10-year yields around zero percent, its steady reduction in purchases of longer-maturity debt and more expensive overseas hedging costs mean Japanese funds are already contemplating bringing more money back home. The BOJ's steps to buy fewer bonds has seen the annual increase in its debt holdings slow to 44.1 trillion yen ($398bn) versus its guidance of 80 trillion yen. Last quarter the reductions were entirely focused on so-called super-long bonds, which are the most attractive to insurers. What happens next in the world's second-largest bond market has the potential to cascade globally given Japanese investors hold $2.4 trillion of overseas debt."

It's a big number: $2.4 TN. BOJ policy has nurtured great Latent Fragilities. For one, policy measures have incentivized Japanese institutions and investors to comb the world for positive yields (fueling Bubbles, in the process). Moreover, there is surely a large yen "carry trade" component, as financial speculators essentially borrow free in yen to leverage in higher-yield global instruments. The dollar/yen bottomed in late March, not coincidently about the same time U.S. and global (developed) equities put in trading bottoms. After trading as low as 104.74, a weaker yen saw the dollar/yen rally to trade last week at 112.88. Having reversed course, the dollar/yen closed Friday at 111.05.

I would argue that the ECB has also nurtured great Latent Fragilities. The ECB Thursday confirmed that policy rates would remain near zero at least through the summer of 2019. "What are they afraid of?" German two-year yields ended the week at negative 0.61%, the French two-year at negative 0.44%, and Spanish yields at negative 0.33%. Even Portugal enjoys negative borrowing costs out to two-year maturities (-0.23%). The German government is paid to borrow out to five years (-0.17%). To be sure, European debt instruments have inflated into one of history's most distorted Bubble markets - and I'll assume Mario Draghi is not oblivious.

Italian 10-year yields jumped 15 bps this week to a four-week high 2.74%. Draghi was again questioned about Target2 balances during the ECB's post-meeting press conference. It's a critical issue that garners surprisingly little attention, perhaps because it is deftly deflected by the head of the ECB. Besides, it was a 2012 worry that proved short-lived.

Journalist: "How do you rate the risk in this [Target2] system, especially for the Bundesbank and compared to the Italy National Bank, for example?"

ECB President Mario Draghi: "First of all, let me make a general point. Target2 is a payment system, as such it doesn't generate instability. It's the way a monetary union settles its payments, and it's devised to make sure the money flows unencumbered across countries, individual sectors, companies - all economic agents. So that's the first thing we should always keep in mind.

The second thing is how to interpret recent numbers which show an increased number of Target liabilities in certain countries. Well, this is again a question that was asked several times in the past. Most of the movement in Target2 liabilities depends on our own asset purchase program - and depends on how and where - especially where - the balances of the purchases of bonds are settled. About 50% of the institutions… that sell bonds to the national central banks are not in the euro area and settle their account with one or two core countries where the financial centers reside. So, in this sense, you see that the accounting settlement of the balances do depend on where the settlement is made. It has nothing to do with capital flows from one country or another. Keep in mind that 80% of the institutions - banks namely - that sell bonds to the national central banks do not reside in the country where the purchaser's national central bank resides. A lot of inter-country payments and flows do not say anything very specific about the overall situation.

But going back to the recent movements in the liabilities in certain countries, you see that first of all they are not unprecedented - this is not the first time. We've seen movements as large and even larger in the past. Second…, they are of second order with respect to the massive movements produced by our own purchase program. So, the bottom line is the system works very well. The people who want to cap it, collateralize, limit - I mean, the truth is that they don't like the euro. They don't like the monetary union. Because the only way a monetary union can work is if they have an efficient payment system - which is what Target2 is. And I think it is just too early to understand exactly what part of the liabilities do reflect political uncertainty."

Italy's Target2 liabilities rose $16.3 billion during June to a record $481 billion, with a two-month gain of almost $55 billion. It's worth noting that Italy's liabilities surged from about zero in mid-2011 to $289 billion at the height of the European crisis back in August 2012. The ECB's "whatever it takes" stabilization program saw these liabilities shrink to $130 billion by July 2014. They've been basically heading south ever since.

Clearly, there is a lack of confidence in Italy's future position in the monetary union. And, at this point, it is not clear what might reverse the steady outflows from Italian financial institutions and assets. I don't completely disagree with Mr. Draghi's assertion that ECB policy is having a significant influence on Target2 balances. When Eurozone central banks buy Italian debt securities in the marketplace, the sellers are choosing to hold (or dispose of) these balances in other countries - thus creating a Bank of Italy liability to another euro central bank (largely the Bundesbank). Why is this not a major festering problem? Germany's Target2 assets rose $20 billion in June to a record $976 billion - having now more than doubled since December 2014.

That Germany will soon have accumulated an astounding $1.0 TN of Target2 assets implies acute Latent Fragility in the euro region. This was never supposed to happen. These balances reflect mounting imbalances plugged by freely-flowing central bank "money." ECB sovereign debt purchases have so compressed interest-rate differentials that there is today insufficient incentive to hold Italian and other "periphery" debt. But a market adjustment toward more realistic Credit spreads risks bursting Bubbles and blowing up debt markets. The entire European monetary integration experiment hangs in the balance.

So, the ECB is forced to stick with negative interest rates and "money" printing operations, and countries such as Italy accumulate liabilities that they will never service, leaving the German people to fret receivables that will never settle. Draghi's assertion that the payment system "works very well" is at best misleading. With imbalances growing bigger by the month, the semblance of a well-functioning payment system depends on monetary policy remaining extraordinarily loose. Stated differently, Acute Financial Fragilities are held at bay only so long as "money" remains free and created in abundance.

I believe we've reached the stage where a meaningful tightening of finance in Europe risks acute bond market instability and perhaps even the entire euro experiment. For those believing this is hyperbole, allow me to phrase this differently: Italy and other "periphery" nations are one financial crisis away from demanding an alternative monetary regime.

A reasonable question: Why then is the euro not under more pressure? Well, Japan is only a meaningful tightening of financial conditions away from major bond market and financial system issues. The yen is a big wildcard. China is only a meaningful tightening away from major financial and economic issues. The renminbi is a big wildcard. The emerging markets are already suffering the effects of a tightening of financial conditions. Many EM currencies are in trouble.

Why is the euro not weaker against king dollar? Because the dollar is fundamentally an unsound currency - in a world of unsound currencies.

July 24 - Wall Street Journal (Josh Zumbrun): "The U.S. remained by far the largest driver of global current-account imbalances in 2017, running the world's largest deficit and adopting policies-mainly a shift toward much larger fiscal deficits-that are likely to increase its imbalances in coming years. The U.S. ran a $466 billion current-account deficit, meaning the nation imported far more than it exported. The U.S. has become an increasingly large driver of global deficits, accounting for 43% of all global deficits last year, up from 39% in 2016, according to the International Monetary Fund's annual assessment of the state of global imbalances. Washington's shift toward major deficit spending will move the U.S. trade deficit 'further from the level justified by medium term fundamentals and desirable policies,' the IMF said."

I would argue that the U.S., as well, is only a meaningful tightening of financial conditions away from serious issues. Inflated U.S. securities markets have been on the receiving end of huge international flows, much a direct consequence of QE (i.e. ECB and BOJ) and rampant Credit growth (China and EM). It would appear that U.S. residential and commercial real estate markets are already feeling the effects of waning international flows.

In the eyes of complacent markets, vulnerabilities - China, Japan, EM, Eurozone, UK, etc. - ensure the coterie of global central bankers remain trapped in aggressive stimulus. Yet there appears increasing recognition within the central bank community that further delays in the start of "normalization" come with mounting risks. That they have all in concert far too long delayed getting the process started ensures great Latent Fragilities.

The Dow jumped 1.6% this week, the Banks 2.4% and the Transports 2.0%. The S&P500 added 0.6%, its fourth straight weekly gain. But the week saw (Crowded Long) declines of 16.7% in Facebook, 21.4% in Twitter, 9.5% in Electronic Arts and 8.2% for Intel. The broader market underperformed. Interestingly, the Goldman Sachs Most Short index dropped 3.1%. Rather abruptly, there are indications of nervousness and vulnerability below the market's surface.

The historic mistake was to believe that aggressive monetary policy would reduce systemic Fragilities. Stimulation of economies and animal spirits, no doubt, but at the cost of mounting latent instability. It's the six-year anniversary of "whatever it takes;" approaching the 10-year anniversary of the financial crisis; going on ten years since the massive Chinese stimulus. This week provided further evidence of trapped central banks.

EM rallied again this week, reducing the safe haven Treasury bid. Two-year Treasury yields jumped eight bps this week to 2.67%. The ten-year is again knocking on the door of 3.0% yields. I have no doubt that a surprising spike in Treasury yields would expose Latent Fragilities. The same question applies to Treasuries as it does to fixed-income markets around the globe: How much speculative leverage has accumulated over the past decade? Keep in mind it's the speculation and leverage that typically dooms a Bubble. Indeed, the interaction of leverage and depreciating asset values becomes a critical factor in why Bubbles are unsustainable.

First, it was the February blow-up of the "short vol" trade. Then instability engulfed the emerging currencies, debt and equities markets, followed by a destabilizing spike in Italian yields. The Chinese renminbi sinks a quick 5%. This week saw further weakness in the Chinese currency, along with hints of instability in Japanese and Italian bonds. Importantly, Beijing stimulus measures come with atypical currency vulnerability.

All in all, the Latent Fragility case is coming together. Financial conditions are tightening, and myriad Bubbles are showing the strain. And while the VIX traded below 12 this week (ending the week at 13.03), my hunch would be that liquidity in the volatility markets has quietly receded. The next VIX spike could get interesting.

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