The First Time as Tragedy
In the past, our ready predisposition to fear the worst has proven to be well-founded. Indeed, through much of the two years leading up to the Great Crash of 2008, there was all too much evidence to ignore that a kind of collective madness had gripped the whole universe of investment world and had spilled out from thence into every plot of building land and every auction house in the real world.
Though at one stage it was said that a certain large Wall Street bank was the world’s most eager buyer of Cray supercomputers in its vain attempt to use them to simulate the behaviour of the complex credit structures its bevy of PhD’s had cooked up for it, the essential game was much simpler. All it involved was to bundle disparate groups of increasingly suspect credits into overleveraged and horribly non-linear packages so that people who should have known better could lend their clients’ hard-earned savings to others of dubious financial standing, content in the knowledge that they had fulfilled the letter, if not the spirit, of their fiduciary duty.
For the bundlers, not only did this shower them with an unprecedented number of pennies in fees to pick up before the advance of what turned out to be a steam-roller of unimaginable bulk and power, but it offered them the juiciest of opportunities to capitalise years’ worth of highly contingent future gains into hard, up-front bundles of bonus-eligible cash, not least when they found that the biggest and supposedly most sophisticated of bond insurers were competing to write cover for them at ever more dreadfully mispriced premium rates.
As a shining example of this lunacy, at one point, one particular prime brokerage struck upon a wheeze of consummate circularity when it ‘securitized’ the future income it could expect from financing its own hedge fund customers’ participation in the frenzy and promptly lent much of the proceeds of that present realisation of an uncertain future – minus bonus deductions, naturally – straight back to those funds so they could generate even more fees to be re-securitized!
Caught up in the whirl was modern art, Swiss watches, classic cars – and all the usual signs of advanced financial psychosis. Credit was being created to sustain all this with barely a thought to the future, as all too many heavyweights were both lulled by the then-Fed Chairman’s risible talk of ‘savings gluts’ and blinded as to the risks by the overconfidence they all came to have that nothing could go wrong because their in-house ‘models’ had predicted that there was no ‘worst case scenario’ dire enough to cause them any loss.
If you doubt the latter, just ask the spokesmen for the three large European investment houses who each assured me personally of this when I questioned them about it at a hedge fund forum in Zurich just weeks before the first ‘models’ indeed started to fail and HSBC made what was perhaps the first public admission of sin with its $10.5 billion mortgage-related write-off, shortly to be followed by New Century Financial’s suspension and bankruptcy.
When all this was eventually revealed as exactly the great folly of which some of us had tried valiantly to warn, it was all too evident, in the immediate, panicky aftermath of the Bust, that once the most drastic response to the emergency had been unveiled, the real problem would be that no-one in authority would have either the foresight, the moral courage, or the political selflessness to discontinue the treatment thereafter.
To our Austrians’ way of thinking, this lack of resolve – coupled with the sort of hubris which would allow ECB member Lorenzo Bini-Smaghi to declare a month after Lehman that no single European bank would ever fail – meant there could be little question that we would be locked into a series of shallow cycles, each taking place around a decidedly lacklustre trajectory of growth. As each timorous attempt to withdraw some of the overly-prolonged stimulus would inevitably give rise to a violent reaction on the part of a market whose pricing was only justifiable in terms of continued, if not intensified, official support, that backlash would be seen to threaten a renewed downturn in the real economy and the effort quickly abandoned.
Does anyone still remember the awful Paul Krugman berating the Swedish Riksbank for having the gall not to slash interest rates at his demand – accusing them of the crime of ‘sado-monetarism’ – and actually managing to browbeat them into a shamefaced reversal of policy which has lasted to this day?
We have our own pet phrase for this: ‘The Ghost of ’37’ (q.v.) – which is an allusion to a much mythologised episode in America’s Great Depression when, faced with a notable surge in both prices and activity, the Fed prudently raised reserve requirements and the formerly spendthrift Roosevelt administration reined back on its wild deficit spending, only for the economy to collapse into a nasty, if short-lived recession.
Supposedly a direct result of this tightening – but in fact much more a result of the legal and political persecution of private business – the lesson drawn by the same central bankers who so pride themselves on not repeating the ‘mistake’ of 1931 is that they must also avoid all chance of sparking off a re-run of the next great ‘error’ committed six years later.
The Second Time as Farce
So, for those for whom money can never be too loose or budgets too unbalanced – as well as for their opponents for whom the sky is about to fall BECAUSE they have been exactly that – the inference is clear: the US economy is not seen to be robust enough to survive even a modest Fed tightening.
Thus it is that both the opposing camps think Yellen & Co will soon not only have to stop, but will flip a full 180⁰ and conduct an embarrassing retreat with regard to interest rates.
As an Austrian of long-standing, your author would never wish to downplay the structural problems which plague a West which has progressively closed the frontier of entrepreneurship by erecting both a wall of regulation across it and by deriding the would-be pioneers who might still wish to cross it. That said, the imminent doom of over-indebtedness has been near-perpetually ‘imminent’ for most of my long career in the markets.
One day, if left as unaddressed as it most likely to be, we shall undoubtedly come to a kind of financial Twilight of the Gods – a conflagration of the social order which will be both terrible to behold and dreadful to have to live through (though we would note that the Nordic Ragnarok was not the end of all things, just of the Aesir who ruled and of the superhuman foes who opposed them, and that it left room for a succeeding Age of Men happily unencumbered by their betters’ conflicts).
But for now, the warning that the lightest touch on the brakes inescapably implies that we we will instantly repeat all the turmoil of 2008 seems just a little too pat; too much a prophesy of doom which has been unimaginatively warmed-over by people who were largely taken unawares by the onset of that last great cataclysm [As explained in our contemporary article ‘Hurricane Cassandra‘, q.v.]
The market therefore finds itself largely trapped: worrying on the one hand about the ever growing mountain of obligations and yet pressed relentlessly forward on the other by the authorities’ mindless monetization of it.
Ahead of Yellen’s collision with the supposedly inevitable, corporate treasurers have been rushing to lock in as much long-term, cheap funding as they can – taking advantage, as they do, of the continued insanity of the ECB and the BOJ and hence of the vast overspill of Flying Dutchman liquidity gushing forth from their respective domains.
Partly because of the need to hedge such borrowing, partly in the hope of profiting from the initial tightening, and partly as an act of rebalancing towards equity markets in the wake of Donald Trump’s electoral success, this has led to the largest ever speculative short-position being built up in US interest rate futures – an aggregate wager on higher yields which amounted, at its peak a few weeks back, to some $2 trillion of 1-year equivalent exposure (OYE).
Needless, to say, the inherent capacity for disappointment which this constituted soon came to weigh all too heavily on the market. Having traded sideways for the majority of the period after the first, violent ‘Trump Bump’, the shorts made a half-hearted attempt to draw more sellers into the game in the wake of March’s modest and well-trailed Fed rate hike. When that all too quickly fizzled out, they instead found themselves reversing into such a stampede of mass liquidation that they drove prices straight out the other end of the range in what was no less than a $650 billion OYE repudiation of what they had convinced themselves just hours before was the right way to trade.
As is usually the case in financial markets, the erstwhile bears were instantly transformed into I-told-you-so bulls – each of them nodding in sage agreement when one of their number took his turn to talk gravely of the failure of Trump’s ‘reflation’ and of the looming US recession which would be its ineluctable result.
As this newest Just So story started to circulate, the macroeconomists helpfully took their airbrush to the Kremlin balcony of data over which they were poring and so quietly de-emphasized the good in the mix in favour of the bad – bricks’n’mortar retail was struggling; auto sales were tepid and used car prices under pressure; delinquency rates were ticking up; and companies had suddenly stopped borrowing (from banks, if not from the barnstorming capital markets themselves).
This was clearly a time to sell stocks and commodities agai and to buy gold and bonds in their place while awaiting the painful volte face now due from the inhabitants of the Marriner S. Eccles building.
Sadly, that, too ran into a brick wall of its own. With the ostensible catalyst that Emmanuel Macron managed to confirm the opinion polls by putting one well-manicured hand on the door to the Elysee Palace, risk was instantly back ‘on’: bonds made good half their preceding yield decline and stock indices surged to new, record highs.
As the balance of confusion swings up and down – the oscillations now being amplified by the fact the all-star Canadian housing bubble appears to be bursting, north of the border – it is too early yet to say if this reaction to the reaction will indeed return us to the prior mix (and hence call forth a display of post hoc rationalization from the sell-side analysts who will have then completed yet another Fouetté to the rear). But bears should perhaps temper their impatience with the realisation that the strong revenue rebound which the macro numbers have been portending seems so far to be translating also into better corporate earnings now that the hidden recession of the shale bust is fading into the history books.
The concurrent rise in the market naturally means that this improvement will do little to alleviate any of our present, easy-money overvaluation. But the feel-good that the headlines will generate among the hordes of specifics-blinded ETF-guzzlers (abetted by the uncaring mechanical impetus of the pattern-following algos which will tend to reinforce the wetware’s unschooled enthusiasm) could well postpone the day of reckoning, once again.
After all, to the extent that past is prologue, Nemesis will probably not arrive, clad in her full panoply of violent disillusion, until right after the last sceptic has thrown in the towel in disgust and thus removed the last bid from a by-then thoroughly hypoxic market.