FLOWS - Liquidity, Credit & Debt

The Fed has created a liquidity time bomb 06-01-15 Nouriel Roubini

Oddly, the more central banks print, the less liquid markets become

NEW YORK (Project Syndicate) — A paradox has emerged in the financial markets of the advanced economies since the 2008 global financial crisis. Unconventional monetary policies have created a massive overhang of liquidity. But a series of recent shocks suggests that macro liquidity has become linked with severe market illiquidity.

Policy interest rates are near zero (and sometimes below it) in most advanced economies, and the monetary base (money created by central banks in the form of cash and liquid commercial-bank reserves) has soared — doubling, tripling, and, in the United States, quadrupling relative to the pre-crisis period.

This has kept short- and long-term interest rates low (and even negative in some cases, such as Europe and Japan), reduced the volatility of bond markets, and lifted many asset prices (including equities, real estate, and fixed-income private- and public-sector bonds).

This combination of macro liquidity and market illiquidity is a time bomb. So far, it has led only to volatile flash crashes and sudden changes in bond yields and stock prices.

And yet investors have reason to be concerned. Their fears started with the “flash crash” of May 2010, when, in a matter of 30 minutes, major U.S. stock indices fell by almost 10%, before recovering rapidly. Then came the “taper tantrum” in the spring of 2013, when U.S. long-term interest rates shot up by 100 basis points after then-Fed Chairman Ben Bernanke hinted at an end to the Fed’s monthly purchases of long-term securities.

Likewise, in October 2014, U.S. Treasury yields plummeted by almost 40 basis points in minutes, which statisticians argue should occur only once in three billion years. The latest episode came just last month, when, in the space of a few days, 10-year German bond yields went from five basis points to almost 80.

These events have fueled fears that, even very deep and liquid markets — such as U.S. stocks and government bonds in the U.S. and Germany — may not be liquid enough. So what accounts for the combination of macro liquidity and market illiquidity?

1-For starters, in equity markets, high-frequency traders (HFTs), who use algorithmic computer programs to follow market trends, account for a larger share of transactions. This creates, no surprise, herding behavior. Indeed, trading in the U.S. nowadays is concentrated at the beginning and the last hour of the trading day, when HFTs are most active; for the rest of the day, markets are illiquid, with few transactions.

2-A second cause lies in the fact that fixed-income assets — such as government, corporate, and emerging-market bonds — are not traded in more liquid exchanges, as stocks are. Instead, they are traded mostly over the counter in illiquid markets.

3-Third, not only is fixed income more illiquid, but now most of these instruments — which have grown enormously in number, owing to the mushrooming issuance of private and public debts before and after the financial crisis — are held in open-ended funds that allow investors to exit overnight. Imagine a bank that invests in illiquid assets but allows depositors to redeem their cash overnight: if a run on these funds occurs, the need to sell the illiquid assets can push their price very low very fast, in what is effectively a fire sale.

4-Fourth, before the 2008 crisis, banks were market makers in fixed-income instruments. They held large inventories of these assets, thus providing liquidity and smoothing excess price volatility. But, with new regulations punishing such trading (via higher capital charges), banks and other financial institutions have reduced their market-making activity. So, in times of surprise that move bond prices and yields, the banks are not present to act as stabilizers.

In short, though central banks’ creation of macro liquidity may keep bond yields low and reduce volatility, it has also led to crowded trades (herding on market trends, exacerbated by HFTs) and more investment in illiquid bond funds, while tighter regulation means that market makers are missing in action.

As a result, when surprises occur — for example, the Fed signals an earlier-than-expected exit from zero interest rates, oil prices spike, or eurozone growth starts to pick up — the re-rating of stocks and especially bonds can be abrupt and dramatic: everyone caught in the same crowded trades needs to get out fast. Herding in the opposite direction occurs, but, because many investments are in illiquid funds and the traditional market makers who smoothed volatility are nowhere to be found, the sellers are forced into fire sales.

This combination of macro liquidity and market illiquidity is a time bomb. So far, it has led only to volatile flash crashes and sudden changes in bond yields and stock prices. But, over time, the longer central banks create liquidity to suppress short-run volatility, the more they will feed price bubbles in equity, bond, and other asset markets. As more investors pile into overvalued, increasingly illiquid assets — such as bonds — the risk of a long-term crash increases.

This is the paradoxical result of the policy response to the financial crisis.

Macro liquidity is feeding booms and bubbles; but market illiquidity will eventually trigger a bust and collapse.

This article has been published with the permission of Project Syndicate — The Liquidity Time Bomb.

JAPAN - Abenomic's QQE Phiosophically Unsound

From Money To Psychology, Japan Reveals The Basis Of Economic Policy Corruption 06-01-15 Submitted by Jeffrey Snider via Alhambra Investment Partners,

At some point in the middle of the last century, economics of money shifted to economics of psychology. When Milton Friedman wrote his 1963 book, A Monetary History, it was an effort that uncovered the role of money in the collapse of the Great Depression as he and his co-author, Anna Schwartz, saw it. Whether or not it was a full explanation, it wasn’t, it became widely adopted as the model for central bank behavior. At its heart, however, it was a treatise about the role of currency and liquidity.

It was still largely faithful to the Bagehot paradigm of central banks as agents of elasticity, with some modification about the terms at which that would be available. It is, however, nothing like what central banks around the world do today, even though outwardly there is a rough resemblance.

Almost as soon as A Monetary History was published there was a shift underway in more general economic theory about taking what was believed the next step – from monetary management to economic management. The impulse in that direction was not new, but the academy about its possibilities was. In 1958, AW Phillips in the UK put together an empirical analysis of a seeming durable correlation between inflation and employment. That was expanded in 1960 by Paul Samuelson and Robert Solow in the United States that posited the Phillips Curve, as it came to be known, as the means to exploit economic factors to introduce greater management and command.

Samuelson, in particular, was immediately welcomed into the Kennedy and then Johnson administrations as an advisor on the subject of that “exploitable Phillips Curve.” What we got out of it was the Great Inflation, a 15-year period of nearly unrelenting disaster that wasn’t just limited to economic malaise, it destroyed the last vestiges of the dollar and introduced the world to credit-based money in the eurodollar standard – the “dollar.”

Coming to terms with the Great Inflation was perfectly reasonable with a reasonable outlook free of determined bias for absolute control and command. Milton Friedman himself played a central role in discrediting the Phillips Curve, but that still left monetary theory short of the ancient Platonic ideal of the central banker as Philosopher King, if only in a limited capacity for creating and nurturing the “optimal” economic results. Despite the Great Inflation, economists did not turn away from trying to attain utopian command ideas, they only set about finding the “right” ones.

Robert Lucas was heavily invested in exactly that, as the allure of “general equilibrium” was so tantalizing to potential economic theory. It meant, as we know all too well now, that, if correct, there was some range of regression equations that could be assembled and constituted such that perfect predictability was possible. That is the idea of general equilibrium in the first place, to be able to model the utterly complex and heretofore mystifying nature of the true economy.

The world into which relatively primitive econometrics worked was centered around the idea of a “general equilibrium.” This was nothing new, as economists since the time of Malthus, Mill and Simon Newcomb believed that there was a method of quantifying any and all economic function. The equations would, as the name general equilibrium implies, have to balance. The central debate ranged around how price changes were set and modified especially owning to monetary and time variables.

What Lucas did, in his famous 1972 paper Expectations and the Neutrality of Money, was to assume generalized equilibrium from the very start. Departing from a regime of “adaptive expectations” Lucas asserted “rational expectations.” What that meant was neutralizing the equations of price expectations so that the difference between actual and expected prices is thus set to zero. In that sense, price behavior could then be adapted under a general equilibrium format, and the whole set of Freidman/Phelps “natural unemployment rate” econometrics would balance (I am simplifying here intentionally).

The generation of economists that undertook Lucas’ rational expectations assumptions saw its promise limited to the mathematical world of econometrics. The generation thereafter, including Ben Bernanke, sought to exploit it not unlike Samuelson and Solow’s attempt with Phillip’s scholarship. Rational expectations become the centerpoint of economic theory, and it has led the “discipline” in very strange directions.

The problem, as with quantum physics, is that “rational expectations” is not a real world phenomenon and certainly not directly relatable or transferable. It sounds as if it may be consistent with our experience of economic reality, as setting the differential of actual and expected prices to zero represents something like total market efficiency. It means that “market” prices are always correct and therefore econometric models need not concern themselves about initial equilibriums – they are always just assumed to be in that state. Inside the math, market prices are thus presupposed to always be market-clearing, and thus not subject to stochastic tests.

Even though the assumption of “rational expectations” is one in which there really appears to be no real-world counterpart, it dominates the centrality of all economic assumptions. Furthermore, like most economic and monetary paradigms, it is unfalsifiable. By adopting “rational expectations” at the start, any statistical tests are thus contained within the paradigm that all “market” prices are true and “correct.” That is a dangerous proposition when real world economic and financial parameters are supposed to flow solely from what is simply a means by which to find a solution within a system of stochastic equations describing only general equilibrium.

Because of this one mathematical property designed only to “save” general equilibrium largely from its own very real limitations, rational expectations has been taken as a real phenomenon to be abused in monetary policy, and thus economic command. If prices are always rational, then the influence of prices will be the same. Monetary policy left money behind and become strictly a tool for influencing behavior – from money and currency to nothing but psychology and the equivalent of happy pills (placebos at that).

We see the results of this shift all around us, especially where economists and “experts” are always so upbeat no matter how ludicrous and isolated such an attitude may be. And then there are the asset prices, going higher and higher to “stimulate” some “wealth effect” of not actual income but, again, happiness over not the direction of the true economy but of what its makers want of your perceptions of it all. It is taken as self-revealing now that even recessions are not much more than “irrational pessimism.”

The lack of recovery everywhere QE is being tried is not actually surprising to anyone but those still believing that rational expectations is anything but a mathematical shortcut. That is true in the US but most especially Japan, where even the mighty QQE has failed to live up to its “unquestionable” power and has thus become to engender very dangerous doubts – unhappy feelings that are the dread of all central bankers under the rational expectations paradigm:

While analysts expect consumption to pick up in coming months, lingering weakness will keep policymakers under pressure to underpin a fragile economic recovery.

“It’s a pretty gloomy number … Consumption may take longer than expected to pick up,” said Taro Saito, director of economic research at NLI Research Institute.

“The mood is good but wages haven’t risen much yet. It might take until around summer for consumption to clearly rebound.”

Reading that economist’s summary would lead you to think that it really is nothing but psychology at work. It is, after all, fully consistent with the stated purpose of QQE to begin with.

Households spent less on leisure and dining out even as the jobless rate fell to a 18-year low, underscoring the challenge of eradicating the sticky “deflationary mindset” that has beset Japan for nearly two decades.

If you think that Japan, or the US for that matter, is suffering from an insufficiency of happiness, a quarter-century funk of nothing but a “deflationary mindset”, then QQE seems a consistent course (never mind the nine prior attempts). If, however, you look at Japan as suffering just madness emanating from monetary policy that is the equivalent of pop psychology, the malaise starts to make perfect sense. The Japanese must be the happiest recipients of impoverishment ever conceived, and the results show. The greatest trick about rational expectations is that it seems so plausible because confidence is a good part of the real economy, but hollow appeals to unrelated factors are not in any way the same as “animal spirits.”

Last month was a difficult comparison because of the April 2014 tax change which pulled forward spending activity into March 2014, and thus the base of the year-over-year comparison was off. So it was expected that household spending would rise in April, with average expectations for +2.8%. Instead, spending declined yet once more, as economists missed their prediction by an enormous 4.1%. The problem with being reliant on illusions is that you can’t spend them; the Japanese, for all the ultra-low unemployment rate jubilee, have very little actual income. Even more recently, real DPI has ticked up but more as a matter of lower CPI and tax comparisons.

Instead, in what matters most, real wages have shown absolutely no tendency toward everything that was expected. When starting QQE more than two years ago, it was fully intended that by now real wages would not just be rising but rising steadily and robustly. Japanese workers have suffered the opposite.

The reason for that is the very way in which the unemployment rate is misleadingly “happy”, connecting wages to what really looks like a still-gathering recession. In the past few months, when this post-tax recovery was supposed to materialize, Japanese businesses have been degrading their labor force, shifting a huge proportion at the margins out of full-time and into part-time. The Japanese still don’t do mass layoffs, instead they just cut hours strenuously while maintaining the “happy” unemployment rate.

I find it very revealing that this remaking of marginal labor utilization is largest in the wholesale and retail trade segments, further confirming the decimation of internal Japanese economics (in the truest sense, not the mathematical theories that dominate). The Japanese people are clearing buying less “stuff” meaning that those who sell stuff are requiring much less of workers in 2015. That is how recessions are made, in that they become self-feeding trends of reduced “demand” and then reduced labor utilization leading to further cuts in income and then demand again.

The problem for econometrics and rational expectations is that any scientific endeavor, and economics very much fancies itself as that, is governed by observation rather than academic stylings even of the most elegant and sophisticated math. Clear observation, now two full years into the emotional bastardization, rejects all conclusions and intentions of the orthodox theories right down to their base foundation. Yet, as noted by the quoted economist above, it will never be falsified by anything other than counter-emotion; rational expectations is so irrational in its persistence because it is no longer even a scientific-like pursuit but a full-blown ideology of religious fervor. No matter how back Japan gets, orthodox economists still say that recovery is later in the year, or next year, or just around some unspecified corner. And it never is; maybe not all prices, especially those highly managed and cajoled, are market-clearing?

The Japanese economy, to any clear mind, took a huge turn for the worst under Abenomics yet its practitioners are still, somehow, given the final word on judging its performance, meaning that the mainstream still, somehow, subscribes to the religion.

Spending by Japanese households slumped unexpectedly in April and consumer inflation came in roughly flat, casting doubt on the central bank’s view that a steady economic recovery will help move inflation toward its ambitious 2 percent target. [emphasis added]

By all scientific observation, there was nothing unexpected about the “gloom” in April.

STUDIES - Stock Buybacks Move to the "Termnal" Next Stage

The Last Two Times This Happened, The Stock Market Crashed

May, M&A deals hit an all-time record of $243 billion.

The prior two record months: May 2007 ($226 billion) and January 2000 ($213 billion). Not long after those records were set, markets crashed with spectacular results.

May included Charter’s $90-billion acquisition of Time Warner Cable and Bright House. Charter will issue around $30 billion in junk-rated debt to accomplish this, likely the second largest junk-debt deal ever, behind that of TXU in October 2007, which is now in bankruptcy [Junk-Debt Apocalypse Later].

May also includes Avago’s $37-billion acquisition of Broadcom, the largest tech deal since the dotcom bubble blew up.

This pressure to buy drives up prices and premiums. And the “synergies” needed to make these deals work even on paper will be harder and harder to come by. “Synergies” is corporate speak for cost-cutting, so mass layoffs, which will be announced with fanfare to push the shares higher. For these companies, it seems the only way to grow revenues is to acquire other companies, and the only way to grow profits is to cut costs. It’s not productive, hurts the economy, and mucks up the future of the company. But what the heck, it looks good on paper.

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The Last Two Times This Happened, The Stock Market Crashed Wolf Richter   www.wolfstreet.com   www.amazon.com/author/wolfrichter

Global growth is languishing, corporate revenues too, but CEOs are trying to show they can grow their companies the quick and easy way. Cheap debt is sloshing through the system while yield-hungry investors offer their first-born to earn 5%. And this cheap debt along with vertigo-inducing stock valuations have created the largest M&A boom the US has ever seen, with May setting an all-time record.

There may be a sense of desperation among CEOs as the Fed’s cacophony evokes interest rate increases, the first since July 2006. So companies are issuing all kinds of cheap debt while they still can. Bond issuance has totaled over $100 billion per month in the US for the past four months, the longest such streak ever, according to Bank of America Merrill Lynch.

And that record issuance doesn’t account for the booming “reverse Yankee issuance,” where US corporations take advantage of the negative-yield absurdity Draghi has concocted in Europe and issue euro-denominated bonds into European markets.

“Issuers should realize that the window to lock in low long-term yields for any purpose is closing,” Hans Mikkelsen, a senior strategist at BofA, wrote in a note, according to the Financial Times. And so in May, M&A deals hit an all-time record of $243 billion.

The prior two record months: May 2007 ($226 billion) and January 2000 ($213 billion). Not long after those records were set, markets crashed with spectacular results.

May included Charter’s $90-billion acquisition of Time Warner Cable and Bright House. Charter will issue around $30 billion in junk-rated debt to accomplish this, likely the second largest junk-debt deal ever, behind that of TXU in October 2007, which is now in bankruptcy [Junk-Debt Apocalypse Later].

May also includes Avago’s $37-billion acquisition of Broadcom, the largest tech deal since the dotcom bubble blew up.

This pressure to buy drives up prices and premiums. And the “synergies” needed to make these deals work even on paper will be harder and harder to come by. “Synergies” is corporate speak for cost-cutting, so mass layoffs, which will be announced with fanfare to push the shares higher. For these companies, it seems the only way to grow revenues is to acquire other companies, and the only way to grow profits is to cut costs. It’s not productive, hurts the economy, and mucks up the future of the company. But what the heck, it looks good on paper.

These deals are financed by a mix of shares, new debt, and cash raised with prior debt issuance – the “dry powder.” Much of this debt is in form of junk bonds and junk-rated leveraged loans, which banks then either sell to loan funds or craftily slice and dice and fabricate into highly-rated collateralized loan obligations (CLOs). Some of these CLOs are then put through the Wall Street sausage maker again to reemerge as tipple-A rated bonds denominated in yen for the Japanese market.

Loading up overleveraged junk-rated companies with more debt – even if it’s cheap – has consequences down the road: US default rates are creeping up, hitting 2% in May, the highest in 17 months, according to S&P Capital IQ’s LCD:

There were eight corporate defaults during the month, and all were public. Magnetation and Patriot Coal filed for bankruptcy; Colt Defense and Tunica-Biloxi Gaming Authority/Paragon Casino skipped bond coupons; Warren Resources and Midstates Petroleum inked sub-par bond exchanges; and SandRidge Energy and Halcon Resources completed bond-for-equity exchanges, also below par.

The report forecast a default rate of 2.5% by December 2015 and 2.8% by March 2016, assuming cheap debt continues to flow without limits. Once the money dries up, defaults will soar. Layoffs and defaults are the bitter aftertaste of M&A booms.

Downgrades are now hailing down on these companies. In May, Standard & Poor’s downgraded 41 issuers with total debt of $71 billion, but it only upgraded 18 issuers with total debt of about $43 billion – for a downgrade ratio by count of 2.28x, more than double the ratio of 1.0x in 2014 and 0.89 in 2013. It’s getting messier out there.

When our corporate heroes are not busy buying each other’s shares, they’re buying their own shares. In April, S&P 500 companies announced an all-time record of $133 billion in buybacks. It’s attracting the ire of the largest money managers in the world.

Blackrock Managing Director Rick Rieder wrote:

While some defend the buyback practice as a method of returning cash to shareholders, others, including my colleague Larry Fink, have argued that some companies today are focusing on maximizing short-term shareholder value at the expense of investing in the future.

In my opinion, today’s boom is just one economic distortion created by the Federal Reserve’s excessively accommodative monetary policy.

The boom is, in essence, a response to today’s extraordinarily low interest rates….

Using debt to fund buybacks and dividends eventually crowds out long-term investment in the company’s core business and threatens its credit quality, which is, according to Rieder, “what we are seeing today.”

Oh, and we almost forgot, there are other consequences. Blackrock’s Rieder:

Indeed, the global economy is witnessing a massive redistribution of wealth and income with borrowers, equity shareholders, and short-term investors benefiting; and savers, bondholders and longer-term investors being placed at risk.

Monetary policy wins again.

Investment bank Natixis just pulled the rug out from under self-satisfied, complacent, monetary-policy-fattened markets. Read…  Today’s ‘Liquidity Regime’ Is ‘Far More Dangerous for Investors’

FINANCIAL REPRESSION - Coming Capital Controls

PROTECTING BANKS FROM THE PEOPLE

The Coming Capital Controls Are Designed To Protect The Banks From You 05-26-15 Submitted by Simon Black via Sovereign Man blog,

Of all the peculiarities about human nature, one of the most interesting in my opinion is that we’re so resistant to change.

Humans simply don’t deal with it well. We tend to root. We find comfort in familiarity.

And, even when the familiar becomes unpleasant, we still put up with it. We prefer to suffer through something that we know rather than change things and risk the unknown.

This is why people stay in bad relationships. Or why they continue working for bosses they dislike at jobs they despise. It’s the fear of change.

But everyone… absolutely everyone… has a breaking point. It’s a point where the status quo becomes so uncomfortable, so painful, that we snap. And walk away.

It’s the same in finance. People stick with what they know, even if they have to endure a little pain and suffering.

Today’s current banking environment is the perfect example. In the US, interest rates for most bank accounts are so low that they fail to keep up with inflation.

You are doing very well if you can generate a whopping 0.5% interest. In Canada rates can be a bit higher.

But when you compare these rates to even the official rates of inflation, it’s clear that savers are guaranteed to lose money.

In Europe it’s even worse. Interest rates at many banks are negative… so savers are actually paying the banks.

In theory there’s nothing wrong with paying your banker, presuming that they’re providing a real service.

Traditionally, banks were no different than a secure storage facility: depositors would pay a fee in exchange for the bank safeguarding their savings.

These days a lot of people might pay 50 bucks a month at a U-Store-It place to store $10,000 worth of junk. So why not pay a small fee for a banker to store $10,000 worth of cash?

The reason is that banks don’t operate like a storage facility.

It’s not like the proprietor of the U-Store-It is loaning out your sofa to make a few bucks on the side. If he were, it would be called fraud, and he’d go to jail for it.

Banks, on the other hand, are actually ENCOURAGED to take your hard earned savings and make a few extra bucks on the side.

In fact they have a history of making often absurd loans and wild, overleveraged bets using your money. Not theirs.

So just consider how insulting this is to actually to pay them interest; paying for the privilege of them gambling with your savings. It’s obscene.

But like I said, we all have a breaking point. And there will reach a level where rates get so low (or negative) that no rational person would continue holding money at a bank.

Why bother? You could just withdraw most of your balance, then pay a small fee for a safety deposit box that you stuff full of cash. Cheaper. Easier. Better.

Cash in your hand might pay 0% interest… but at least it doesn’t cost you.

But there’s a huge problem with this approach: there’s very little physical cash in the system.

According to the Federal Reserve, the amount of physical US currency in circulation is about $1.3 trillion. Yet the amount of “M2” money supply is nearly ten times that amount.

So just imagine if even 10% of people hit their breaking points and withdrew their money in cash– there wouldn’t be enough cash in the system to support this demand. And the banks would subsequently collapse.

If governments have proven anything to us over the last seven years, it is that they will do anything to keep the banks from going down.

This is a major reason why they’re trying to get rid of cash, and in some cases even criminalize it under the ridiculous auspices of the war on terror.

In the US, some of the more prevalent names in finance have started calling for an outright ban of cash, including a prominent economist from Citigroup.

(This is a rather convenient position for Citigroup.)

Greece is another great example– they’ve already implemented a tax on cash withdrawals and wire transfers. And further restrictions will inevitably follow.

These measures are all different forms of capital controls, designed to prevent you from taking your money away from such a destructive system.

In fact, I expect the next round of capital controls will be designed to protect the banks… from you.

When a government is bankrupt, the central bank is nearly insolvent, the banking system is illiquid, and an entire population suffers from interest rates that are either negative or below the rate of inflation, capital controls are a foregone conclusion.

They’ll hit just as soon as enough people reach their breaking points… when they say ‘enough is enough’ and they take their money out of the banking system.

Governments have done it before: they’ll declare a ‘bank holiday’ and then impose some sort of freeze on withdrawals. Just like we saw in Cyprus in 2013. Or the US in 1933.

The data and history are very clear on what will likely happen. We just can’t pinpoint the date.

Very few people will guess correctly and withdraw their cash the day before capital controls are imposed.

That’s why it makes sense to take certain steps now.

Consider holding some physical cash, including some healthier currencies like the Swiss franc or Singapore dollar, as well as precious metals.

More importantly, consider moving a portion of your savings to a rainy day fund at a well-capitalized bank overseas in a jurisdiction that isn’t bankrupt.

After all, it’s hard to imagine that you’ll be worse off for having some savings at a strong, healthy bank that actually pays a reasonable rate of return.