Losing Control

By Guy Haselmann of Scotiabank

Losing Control

Markets are beginning to signal that policy makers are losing control.  Many second-order-effects of the unprecedented and experimental global actions taken since the 2008 crisis are beginning to manifest.  There are always causes and effects that develop; but they do so at different speeds. Many actions in recent years have prioritized 'benefits today' over 'consequences tomorrow'.  'Tomorrow' is approaching ever more quickly. There is no 'free lunch'. 

Market damage and volatility due to policy interference, or due to the deliberate influence of security prices, are a shame.  Markets should ideally operate with unencumbered fluidity. Markets should operate in a manner where adjustments to new information allow buyers and sellers to rapidly, and seamlessly, find a natural clearing price.  Authorities and regulations should be like good referees in a soccer match; they provide the conditions for a fair match, and you rarely notice their presence.

  • The beginning-of-the-end of official control happened earlier this year when the Swiss National Bank (SNB) retracted its currency-peg-promise, triggering a 40% move in the G-7 currency in 10 minutes. 
  • In early May, shortly after the SNB event and the launch of ECB QE and EU negative interest rate experiments, the EU bond market became dysfunctional.  The absurdity of sustaining $4 trillion of negative rates came into focus. The German 10-year Bund moved from 0.05% to 0.75% in under a month.
  • A series of Greek policy and troika bailout mistakes - actions that never resulted in a realistic and sustainable solution - are now culminating toward a tipping point. 
  • Chinese authorities that have allowed and encouraged an equity bubble to manifest (and other central banks for that matter) are starting to see how ‘bubble blowing’ typically ends.  Other central banks are hopefully watching.  Chinese equities have lost $3.2 trillion in value in 30 days.  To put this into perspective, this is equivalent to the entire stock market capitalization of Germany and France combined.

After implementing numerous procedures that encouraged equity risk taking, Chinese officials this week seemed fraught to stop the free fall in prices before it began to affect the broader economy, or led to social unrest. Officials have cut bank reserve requirements and interest rates.  They have advertised and published stories about the soaring stocks and upside potential. They have channeled pension assets into shares. They have targeted short sellers, suspended IPOs (to allay dilution), decreased trading fees, and loosened margin requirements. The Chinese central bank has also provided liquidity to state entities that make margin financing available to stock brokers. None of these actions are good for (free) markets.

  • It appears China might not be learning from history.  In 1999, margin debt ran amok in NASDAQ doubled the index - which was followed by a 78% crash.  The subsequent FOMC easings and prolonged over-accommodation then fueled the housing and credit bubbles.

Too many central banks have entered into a dangerous trade-off:  providing excessive monetary accommodation (despite questionable economic benefits -particularly at the Zero Lower Bound) in order to lift equity markets, versus allowing financial instability to cultivate and amass.  This tradeoff embodies the fears of both FOMC camps: the fear of hiking too soon versus the risks of waiting too long.  There are enormous consequences on both sides - all of which are poorly understood.

Even those who do not believe that US equities are in a bubble (or that moral hazard troubles are rampant) must admit that debt issuance from low interest rates are at colossal levels.  The amount of debt issuance has broken a new record four years in a row.  The last two quarters are the largest quarters ever. 

This moonshot of global levels of indebtedness will be an economic headwind for decades to come particularly if and when interest rates rise.  Maintaining a policy tool that encourages such massive indebtedness (public and private issuance) is imprudent long run policy.  As mentioned above, it mortgages the future while attempting to immediately boast equity prices and economic activity. This trade-off has failed to play out as officials suspected; otherwise debt-to-GDP levels would have fallen. 

It is the Fed’s zero interest rate policy foremost that has provided the opportunity for the debt issuance to occur in the first place. As the Volcker Rule launches on July 20th, market making and liquidity will soon deteriorate further; a troubling result of over-zealous regulators.   In addition, a large portion of the debt issuance proceeds have gone into share buyback, further fueling the illusion of healthy EPS improvement.

Despite various attempts at redistribution, policies have also widened wealth inequality. As this gap widens and the underlying problems in the economy merely get patched-over with temporary remedies, social unease builds, giving rise to fringe political parties.  

Today, China’s extraordinary market meddling resulted in a one day reprieve from the recent implosion in various commodity, currency, and equity markets.  However, it is likely to prove temporary.  Where there is smoke there is fire, especially in China.   Typically, official information and data is often disregarded because it is taken with a healthy dose of skepticism.  In contrast, the magnitude of the drop in commodity and Chinese equity index prices is real and should be taken as a warning sign.

Chinese build-up of imbalances probably has much further to run after years of gargantuan stimulus.  Recent policy actions are likely to prove insufficient to arrest those adjustments.  Chinese troubles are likely to prove more important to markets in the near term than Greece.  Chinese troubles are unfolding now, they are immediate, and they are vast. The Greek tragedy will continue to unravel but do so more slowly with fits and starts, via false hopes, humanitarian aid, misinformation, and political posturing (more on Greece tomorrow). 

It has yet to be seen how the aggressive policies of the Fed, BoJ, and ECB eventually play out, but there are plenty of  signs that markets will not be as composed and containable as they had hoped.

“The government solution to a problem is usually as bad as the problem”.

    – Milton Friedman