What’s The Yield Curve Saying About Asia And The Bubble Cycle?
-The Ultimate Black Swan-Armageddon
-The Cyclical Nature Of Bubble Cycles
-Measuring Boom Bust Cycles Via The Yield Curve
-What’s The Yield Curve Saying?
-Bubble Cycles Do NOT Discriminate
The Ultimate Black Swan-Armageddon
WATCHING National Geographic’s ‘Apocalypse How’ made me realize how the world is so vulnerable to the exogenous forces of nature and how man could be completely helpless in the face of such overwhelming power.
Yes, you may forget the farcical anthropogenic climate change, because the forces of nature would be exponentially be way far far far far more powerful and potent than the outcome from any of our collective destructive actions.
Besides, as remarked by the scientists interviewed in the TV documentary program, like any part of nature, our world operates on its own cycle. This means that the “ice age” could be just around the corner in some thousands of years to come, while the sun will expire on its own, by running out of fuel to burn, in about 5 billion years, and that today’s “aging” earth, even without the sun’s demise, will likely meet its end on its own.
And the sad part is that there is nothing mortal man can do to stop it. Every species or anything else that is part of nature will cyclically become extinct.
While we have been made aware by media of these apocalyptic scenarios through a variety of science fiction movies that could or may occur; such as huge asteroid/s crashing on earth, super volcano eruptions, alien invasion, robot uprising and many more, there are other factors such as the black hole, gamma rays from an imploding star or the unleashing of a mighty wave of solar flares from our sun, that could send our world into oblivion, unpredictably and instantaneously.
This would be the ultimate black swan for us- a low probability high impact event- our Armageddon.
Even in nature we see the variances of applied risks:
-cyclical risks (demise of sun or earth)-which if we are lucky enough would allow the Homo sapiens species commodious time to prepare for such eventuality through technological innovations and applications that could enable our descendants to scour other parts of universe for relocation
- and the Black Swan risks, which I guess leaves us to get insured with the Almighty.
The good news is that cycles extrapolate that for every death means a new birth somewhere. It’s just that we won’t be appreciating it, since we can’t know everything even when we’re alive, and perhaps because it is least of our concerns- since it ain’t about us.
However, in the understanding of nature’s dynamics, as consolation, a new life is taking place…somewhere.
The Cyclical Nature Of Bubble Cycles
This brings us back to the markets.
The difference between dealing with the complex forces of nature and that with actions of human beings is that the cyclical risks factors appear much magnified in the latter than the randomness elicited from the former.
But in contrast to the presumptive fallacious assumptions of the self-righteous aggregatists, the less complexity of social science doesn’t translate to technocratic omniscience since social sciences remain fluid, dynamic and adaptive to the constantly changing environments. Importantly they aren’t mechanistic.
The reason is that human actions are based on incentives: People are guided by what they perceive as satisfying some ends by engaging in specific means as distinguished by the scale of values (marginal utility) and time preferences, which comes in two parts-a low and high preference. In the Austrian School, low time preference means long term while high time preference means short term.
Interest rates function as major incentives in ascertaining the allocative (savings, investment and speculation) decisions of economic agents. To quote Professor Ludwig von Mises on interest rates and its money relation, ``The final state of the market rate of interest is the same for all loans of the same character. Differences in the rate of interest are caused either by differences in the soundness and trustworthiness of the debtor or by differences in the terms of the contract. Differences in interest rates which are not brought about by these differences in conditions tend to disappear. The applicants for credits approach the lenders who ask a lower rate of interest. The lenders are eager to cater to people who are ready to pay higher interest rates. Things on the money market are the same as on all other markets.”
In other words, in a laissez faire environment, creditors and debtors have essentially the same incentives as with buyers and sellers- both parties compete with their own class to serve the other parties or to satisfy the market, whereby both seek the price levels which satisfy their interests. Therefore, the rates of interest are determined by the demand and supply of credit through time preferences.
Unfortunately we aren’t in laissez faire environments where central banking has usurped the function of free markets in an attempt to perpetuate boom cycles via interest rate manipulation.
In Making Economic Sense, Murray N. Rothbard describes the boom bust cycle from monetary expansion primarily from interest rate controls (bold highlights mine), ``Inflationary bank credit is artificial, created out of thin air; it does not reflect the underlying saving or consumption preferences of the public. Some earlier economists referred to this phenomenon as "forced" savings; more importantly, they are only temporary. As the increased money supply works its way through the system, prices and all values in money terms rise, and interest rates will then bounce back to something like their original level. Only a repeated injection of inflationary bank credit by the Fed will keep interest rates artificially low, and thereby keep the artificial and unsound economic boom going; and this is precisely the hallmark of the boom phase of the boom-bust business cycle.
``But something else happens, too. As prices rise, and as people begin to anticipate further price increases, an inflation premium is placed on interest rates. Creditors tack an inflation premium onto rates because they don't propose to continue being wiped out by a fall in the value of the dollar; and debtors will be willing to pay the premium because they too realize that they have been enjoying a windfall.”
So in contrast to the myopic mainstream, which sees the market as operating in some ‘randomesque animal spirits’, interest rates mold the public’s mindset (not just capitalists or speculators but also workers, housewives and everyone else) as to how money gets allocated.
In short, boom bust episodes don’t come by haphazard chance; they function like nature, they are cyclical. Importantly, inflationism also reflects on the conditions of money.
Measuring Boom Bust Cycles Via The Yield Curve
Figure 1: Steve Hanke, stockcharts.com: Austrian Trade Cycle And The 2003-2008 Bubble Cycle
Where interest rates have been distorted to create a false impression of the abundance of savings via central bank injected money from thin air, the allure to invest in long term projects becomes relatively more compelling (see figure 1, left window).
That’s the reason why Americans and many bubble economies of the world had been seduced into the real estate bubble trap in various degrees.
Cato’s Steve Hanke describes how the process evolved (all bold underscore mine), ``An artificially low interest rate alters the evaluation of projects – with longer-term, more capital-intensive projects becoming more attractive relative to shorter-term, less capital-intensive ones.
``Austrian theory played out to perfection during the most recent boom-bust cycle. By July 2003, the Federal Reserve had pushed the federal funds interest rate down to what was then a record low of 1%, where it stayed for a full year.
``During that period, the natural (or neutral) rate of interest was in the 3-4% range. With the fed funds rate well below the natural rate, a credit boom was off and running. And as night follows day, a bust was just around the corner.”
As you can see in the right window of figure 1, during the dot.com bust, the US Federal Reserve hastily pared interest rates that pushed up or sharply steepened the yield curve (spread between 10- year and 2- year spreads-blue trend line).
Since interest rates always impact the markets with a time lag, the S & P responded and began to rise in 2003, or about 2-3 years after.
Then the US Federal Reserve began to lift policy rates in June 2004, thereby reversing the monetary easing as shown by the flattening trend of the yield curve.
The flattening of the yield curve subsequently led to the peak of the US real estate industry in 2005 (more than a year after), again with a time lag, as shown in our charts in China And The Bubble Cycle In Pictures, and eventually crashed in 2006 (see here for Case Shiller update).
The aftermath similarly had the US and global stockmarkets belatedly react by gradually unraveling in 2007. The culmination of which was manifested by a spectacular collapse that had been heralded by the infamous Lehman spectacle of September 2008. The crash proved to be the capitulation or the turning point for the markets.
What’s The Yield Curve Saying?
So where’s the yield curve now?
Figure 2: stockcharts.com: Skyrocketing Yield Curve
This noteworthy observation from moneyandmarkets.com’s Mike Larson, ``We just saw the spread between 2-year Treasury Note yields and 30-year Treasury Bond yields widen to 379 points. That’s the highest in almost three decades of record-keeping. And the 10-year TIPS spread I’ve highlighted on multiple occasions blew out to yet another 18-month high of 246 basis points earlier this week.” (emphasis his)
This means that the incentives to profit from the yield curve arbitrage have never been as compelling as before. Investors will likely be tempted to borrow short and invest long.
Meanwhile, for financial intermediaries they will be incented to enhance their maturity transformation or conversion of short term liabilities (deposits) to long term assets (loans).
So both the demand and supply variables will likely be responding positively to the incentives provided by the gaping interest rate spreads as a result of policy distortions.
As you can see in the chart above, like in the past, world markets ($DJW) have belatedly responded to the steepening of the yield curve, albeit faster than in the previous cycle- the recent reaction had 1½ years lag compared to previous 2-3 years lag.
The faster response appears to have been abetted by the Quantitative Easing (QE) program, aside from other guarantees and other Federal Reserve as the “last resort functionaries” seen in diversified alphabet soup to the tune of TRILLIONS of dollars.
Moreover, gold ($gold) appears to be resonating the current undulations of the yield curve.
As caveat, correlation isn’t causation. This isn’t to suggest that gold has been driven by the yield curve arbitrage. What can be casually observed is gold’s apparent rhythmic symmetry with the curve during the past 3 years.
It must be remembered that Gold has risen in spite of the current and previous easing-tightening policy cycles, which experienced two boom-bust episodes during the last decade. Gold has been up for 9 straight years with an average of 17.1% returns denominated in US dollars (James Turk)!
Bubble Cycles Do NOT Discriminate
SUBSIDIZED interest rates are likely to generate borrowing traction for institutions or industries or countries which had been LEAST blemished by the recent bubble.
This had been elaborated by both Professor von Mises- where credit take up is ``caused either by differences in the soundness and trustworthiness of the debtor or by differences in the terms of the contract”- and by Professor Rothbard’s description of the impact of such policies- ``As the increased money supply works its way through the system, prices and all values in money terms rise, and interest rates will then bounce back to something like their original level”-as duly noted above.
China’s recent response to increase bank reserves, aside from last week’s higher T-bill sales, is on path to this as discussed in Asia And Emerging Markets Should Benefit From The 2010 Poker Bluff.
Figure 3: McKinsey Global Institute: Leverage of Financial Institutions
It is also the major and fundamental reason why major emerging markets and Asia have fundamentally outclassed and significantly outsprinted developed economies in 2009 and why it would likely do a similar rendition in 2010.
Again, specifically because low systemic debt, high savings rate, least affected banking system (see figure 3) and importantly the increasing adoption of economic freedom among other variables have allowed policy impelled circulation credit to percolate more within the national borders and within the region in a relative scale compared with other parts of the globe.
And this is why many have been aback by the sudden surge or the rampant improvement in Asian and major emerging markets financial markets, which have prompted some skeptics to call a “top”.
Figure 4: Bloomberg Chart of the Day: Asian Outperformance
For instance, the combined European sovereign Credit Default Swaps (CDS) or a gauge of default risks of the PIIGS (Portugal, Italy, Ireland, Greece and Spain) have spiked more than those of their emerging Asian counterparts (see figure 4-upper window) for the first time in history as measured by the CDS. This implies that Asian debts have been inferred as less risky than its European peers.
By using non sequiturs or the implication of political risks such as “nuclear armed neighbour”, “number of political coups”, “unstable neighbour” or “imposed currency controls”, an analyst calls for a “top” for emerging markets based on what he thinks as unrealistic valuations and euphoric sentiment that replicates 1994.
The analyst appears to have forgotten about the ``differences in the soundness and trustworthiness of the debtor or by differences in the terms of the contract”, which serves as the essence of what default risks is about.
Where the PIIGS have taken on debt more than they can afford to pay for, they were ultimately found swimming naked when the tide receded, to paraphrase Warren Buffett.
The markets have, in essence, justifiably priced such debt laden PIIGS as relatively more likely to default than the Asian peers, because the latter have learned, endured and painfully adjusted from the excesses of the Asian crisis (twelve years past) and have engaged in a more circumspect borrowing and lending activities and eluded emulating the West’s risky behavior during the last bubble cycle. [Although eventually persistent bubble policies will likely force us to embrace extravagance]
In the same context, we see a parallel in the default risks dynamics manifested on corporate debt ratings via VIX indices (figure 4-lower window). Americans have been perceived as having the most relative risks, the UK second and lastly China (go back to figure 3 to answer any whys).
Besides it would signify as spurious analysis to anchor on past performance. Who would have ever thought that Iceland, once belonging to the world’s elite, has fumbled? [see Iceland's Devaluation Toll: McDonald's and Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?]
In short, bubble cycles have effectively sanctioned credit extravagance with no palpable discriminations; because it is a market imposed discipline.
Once it had been the Asians and now it is the turn of the Europeans and the Americans. That’s how the cycle, under the laws of scarcity, operates.
So the general rule is whoever inflates eventually suffers from the consequences of such political actions (yes inflation is fundamentally a political decision), irrespective of the identity (nationality) or present and past financial or economic standings or political or culture framework.
For now, markets appear to have been rewarding the prudent.
And like the forces nature, there are cyclical risks that one can insure against and there are black swan risks.
No comments:
Post a Comment