RBS: Asia Has a Credit Bubble!

Like Thailand, Philippine officials will likely continue to stubbornly contradict publicly on the risks of bubbles, yet as I recently pointed out, recent events in Cyprus only reinforces the perspective of how regulators can hardly see or anticipate bubbles until fait accompli or until the ex-post materialization of the advent of a crisis[1].

And it would seem that more from the mainstream are becoming aware of elevated risks of Asia’s credit expansion. (yes, I am not alone)

The Royal Bank of Scotland (RBS) practically notices all the symptoms I have been elaborating as effects or symptoms of bubbles.

They note that bank deposits have not kept the pace with rate of credit growth. They also noticed that the focus on domestic consumption coincides with rising credit levels and the loosening of credit conditions (left window). Savings have also been in a conspicuous decline.

Remember consumption is a function of income. Outside income, more consumption can only be attained by virtue of borrowing and by running down of savings. Borrowing represents the frontloading of consumption. Expanded consumption today eventually leads to lesser consumption tomorrow as the borrowers would have to pay back on the interest and principal of debts.

As I previously noted[2]

My explanation revolved around examining the 3 ways people to consume; productivity growth (which is the sound or sustainable way) and or by the running down of savings stock and or through acquiring debt (the latter two are unsustainable).

So the decline in deposits and savings as credit expands are signs of capital consumption.

The RBS also observed that the ballooning of credit have come amidst the backdrop of falling labor productivity while the region’s balance of payments had rapidly been deteriorating.

Declining savings and the diversion of household expenditure towards debt financed consumption goods leads to capital consumption, thus the decline in productivity.

Artificially suppressed interest rates, which penalizes savers and encourage speculation in the financial markets and other unproductive uses of capital, mainly through the concentration of speculative investments or gambles on capital intensive projects, e.g. property, shopping mall, casinos, are symptoms of malinvestments. So instead of promoting productive investments, low interest rates serve as another source of productivity losses.

The RBS equally notes that India, Indonesia and Thailand have become balance of payment ‘deficit’ countries whereas Malaysia’s surplus has been sharply declining. The regions banks’ loan-deposit ratios have likewise substantially increased to uncomfortable levels (right window).

When nations spend more than they produce, then such deficits occur. And deficits would then need to be financed by foreigners or as I previously noted “would need to be offset by capital accounts or increasing foreign claims on local assets”[3]. 

And with more countries posting deficits, then the increased competition for savings of other nations will translate to increased pressure for higher domestic interest rates. Yet greater dependence on foreigners increases the risks of a sudden stop or of a slowdown or reversal of capital flows.

On the same plane, when domestic spending is financed by domestic debt then deficits grow along with rising local debt levels.

The deterioration of real savings or wealth generating activities and the expansion of bubble activities only increases the risks of a disorderly adjustment (bubble bust) which may be triggered by high interest rates or by interventions to reverse the untenable policies or by sudden stops or by plain unsustainable arrangements or even a combination of these.

The RBS also comments that household debt ratios particularly in Hong Kong Malaysia and Singapore have increasingly transformed into a fragile state, accounting for over 65% of GDP. Worst is that household wealth has nearly been concentrated in property, which makes the region’s wealth highly vulnerable to higher interest rates and a decline in property prices.

Overreliance on debt which has been used for unproductive and consumption activities only increases people’s sensitivity and susceptibility towards upward changes in interest rates that are likely to affect asset prices and economic performance.

This is known as the bubble cycle.

The RBS as quoted by the Reuter’s Sujata Rao[4],

What is however worrying is the pace of credit growth. …The combination of rapid credit disbursals and more importantly, the on-going divergence between credit disbursals and GDP growth implies that the system is becoming more vulnerable to income and interest rate shocks.

Again while such imbalances may not have reached a tipping point or the critical mass yet and which may not likely impact the region over the interim, everything will depend on the “pace of credit growth”.

And a manic phase will likely goad more debt acquisition in order to chase yields.

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[1] see The Anatomy of the Cyprus’ Bubble Cycle March 24, 2013

[2] see Shopping Mall Bubble: The Quibble Over Statistics January 29, 2013

[3] See E-Vat 15%: Possible Consequence from Current Quasi Boom Policies December 10, 2012

[4] Sujata Rao Asia’s credit explosion, Global Investing Reuters.com March 22, 2013

The Impact of Open Ended QEs on Asia: Bubbles or Stagflation

At least some foreign experts have an idea of the risks posed from inflationist policies, adapted by political authorities of developed economies, on Asia.

From CNBC-Finance.yahoo

The Federal Reserve's measures to revitalize the U.S. economy pose risky side effects half way across the world in Asia, warn experts, particularly in the form of asset bubbles driven by an inflow of speculative funds into the region.

Pumping cash into the U.S. financial system tends to have a spillover effect on other parts of the world and Asia, in the past, has been a big beneficiary of the extra cash looking for a home.

"The problem is that the Fed is simply not paying attention to Asia because they are so concerned about the internal economic dynamics in the U.S. and they are trying to resuscitate the U.S. labor market," Boris Schlossberg, Managing Director, BK Asset Management told CNBC Asia's "Squawk Box" on Friday.

"It is creating a bifurcated result where you (get) higher asset prices, but not necessarily quality growth," he added.

Hot money flows into the region are likely to return.

Currency debasement policies in the developed nations would motivate investors to move funds elsewhere. This has been widely known as “the search for yields” which in reality signifies as a capital flight dynamic where investors seek refuge for savings.

More from the same article:

The Fed announced on Thursday its third round of monetary stimulus, in which it pledged to buy mortgage related debt and other securities until the country's labor market showed sustained improvement.

The last two rounds of quantitative easing in 2009 and 2010 resulted in massive capital inflows into the region of $66 billion and $96 billion, respectively, according to data from the Asian Development Bank (ADB), some of which was withdrawn in 2011, contributing to a subsequent slump in markets.

The ADB warned earlier this week that history could repeat itself should the region be hit by a surge in speculative fund inflows, adding that policymakers should brace for a scenario where money exits the region as quickly as they entered.

Vishnu Varathan, Market Economist at Mizuho Corporate Bank, says Asia could see an even higher level of capital inflows this time around, since the Federal Reserve is unlikely to be the only major central bank launching renewed quantitative easing - the European Central Bank, for instance, may also step in with asset purchases.

He says the region's property market is most vulnerable to sharp price increases, particularly in countries such as Singapore and Hong Kong - where the seeds were sown a few years ago from previous rounds of monetary stimulus - and nascent markets like Indonesia.

Earlier I postulated that intensifying inflationism in Japan and in western nations will drive savers (or the capital flight dynamic) into Asia. This should include the Philippines.

But since (inward) capital flows into ASEAN will reflect on global central bank activities, this dynamic would not be limited to Japan but would likely include western economies as well.

With the Fed and the ECB riding into the open ended-unlimited options, it’s not far fetched for central banks of Japan (BoJ), England (BoE) and others to join the club.

By putting a cap on the Euro-Swiss Franc, the central bank of Switzerland (SNB) have been the frontrunner of the open ended asset purchasing policy options where signs of internal bubbles have emerged.

Yet unlimited inflationism will likely to spur consumer price inflation that increases the risks of stagflation especially on emerging Asia.

Vasu Menon, Vice President, Wealth Management Singapore, adds that rising prices will pose a challenge for Asian central banks going forward.

"I think central bankers are worried about inflation - the Philippines for example held its rates steady because they are concerned about inflation," Menon said, referring to a decision by the Philippine central bank on Thursday to leave its benchmark interest rates steady at 3.75 percent.

As I recently wrote,

High commodity prices are likely to influence emerging markets consumer price inflation more. Food makes up a large segment of consumption basket for emerging Asia including the Philippines. This would prompt for their respective central banks to reluctantly tighten. Monetary tightening will put pressure on the stock market.

Stagflation, thus, also represents both a contagion and internal (political and market) risk for the Philippines and for emerging Asia.

Yes the risk ON environment has been re-triggered by massive inflationism by the Fed and the ECB.

And one of the above risks (a bubble or stagflation) will become a force to reckon with in Asia, possibly in 2014 or 2015. All these will essentially depend on the feedback mechanism between the dynamics at the marketplace and policy responses on them.

The Deepening Gold Markets of Asia: Hong Kong Opens New Gold Storage

Gold markets in Asia will get a huge boost from the opening of Hong Kong’s largest gold storage

From Bloomberg,

Hong Kong’s largest gold-storage facility, which can hold about 22 percent of the bullion now in Fort Knox, will open in September to meet rising demand from banks and the wealthy, according to owner Malca-Amit Global Ltd.

The facility, located on the ground floor of a building within the international airport compound, has capacity for 1,000 metric tons, said Joshua Rotbart, general manager for the Hong Kong-based company’s Malca-Amit Precious Metals unit. Two of the vaults may hold assets, including gold, for banks and financial institutions, and others will be used for diamonds, jewelry, fine art and precious metals, said Rotbart.

The move in Hong Kong reflects increased demand for gold in Asia even as the commodity struggles to sustain its rally into a 12th year. Gold-demand growth in China, the world’s second- largest user after India last year, is slowing, according to the World Gold Council. Vault charges will depend on each customer’s operations, according to Rotbart, who declined to give a figure for the venture’s cost beyond millions of dollars.

Reports attribute this to the growing wealth in Asia, from the same article…

Asia-Pacific millionaires outnumbered those in North America for the first time last year, according to Capgemini SA and Royal Bank of Canada’s wealth-management unit. The number of individuals in the region with at least $1 million in investable assets rose 1.6 percent to 3.37 million, helped by increases in China and Indonesia, according to the firms’ World Wealth Report, released last month. So-called high-net-worth individuals in North America dropped 1.1 percent to 3.35 million.

Gold markets in Asia will likely become more competitive, from the same article…

The new storage facility will compete with services offered by the Airport Authority Hong Kong, which began storage operations at a 340 square meter site in 2009 for government institutions, commodity exchanges, bullion banks, refiners, wealthy individuals and exchange-traded funds. Capacity is reviewed on a regular basis to ensure there is adequate storage over the medium term, the authority said in a statement.

Singapore’s Push

Singapore is also among economies in Asia vying for a greater share of the bullion trade. In February, the government announced a plan to exempt investment-grade gold, silver and platinum from a goods and services tax, starting from October. The aim is to raise the city-state’s share of the global gold trade to as much as 15 percent in five to 10 years from about 2 percent, according to IE Singapore, the external trade agency.

Competitive gold markets are signs of the burgeoning free markets in Asia.

Besides, gold has been embedded in the culture for many Asian nations (e.g. India, Vietnam, Malaysia, China, etc…), which I think is why the “gold as money” theme will be more receptive to Asians.

Yet this seems to exclude the Philippines, where much of the public still cling to the romanticized notion that the US dollar represents as THE ultimate currency—this seems tied to the popular social democratic mindset which gives mandate to the political economy of state (crony) capitalism.

I believe that the Asia’s blossoming gold market has been more than just about the showcase of wealth, but about gold as insurance…which essentially may pave way for gold to reclaim its role as money.

Perhaps this may signal that Asia may lead the world towards the restitution of sound money.

A Very Eventful Week: Philippine Elections And The Euro Bailout

``It's simple: when the utility of what you want (however you measure it) is less than the cost of the debt, don't buy it.” Seth Godin, Consumer debt is not your friend

The past two weeks have been quite eventful both in local and in international terms.

From an international perspective, we’ve been seeing the unfolding of the controversial political developments in Europe, which has apparently sent markets into steep pendulum swings.

From the local perspective, the culmination of the national elections has added to the ongoing optimism in domestic market activities as seen in the Peso and the Phisix.

And this seems to have partially created a divergence which has resulted to an outperformance (see figure 1).

Figure 1: Phisix Outperforms Global Markets

As to whether the Phisix and the Peso can sustain these divergences outside the sphere of global influence remains to be seen.

In the chart, fundamentally the undulations of the Phisix, has coincided with the actions abroad, i.e. the US S&P 500 (SPX), Europe’s (Stox50) and Dow Jones Asia (DJP1), as revealed by coincidental troughs from the Greece tremors last February (vertical line), aside from the sharp selloff during the other week which also signified as a sequel of the previous Greece episode (arrows).

Let me add that Friday’s selloff in the international markets have yet to be factored in the Phisix.

The point is, it would seem fallacious to assert that the local markets have been operating independent of global influence until last week.

Where the Phisix has broken out of the consolidation to a 25 month high last week, we can only discern that such buoyancy had been a consequence from the recent local elections.

All told, we have been validated anew that election jitters or risks had only been an exaggeration[1] apparently a figment of imagination of media and the politically obsessed groups.

Further, news reports where the nation was supposedly stunned[2] by the speed of election count only reveals of the backward orientation held by the public with regards to the current state of technological capability. Yet in today’s technology enhanced real time world, these returns, while fast, have not been impressive, or fast enough.

Nevertheless, the question in our mind is whether the Phisix will manage to sustainably diverge from the global markets, or if the current pressures seen in the global markets imply for a reversal, which may eventually affect the performance the Phisix.

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[1] Why The Presidential Elections Will Have Little Impact On Philippine MarketsPhilippine Markets And Elections: What People Do Against What People Say and

[2] Inquirer.net, Fast count stuns nation

Phisix: The Philippine Presidential Honeymoon Cycle Is On

``Most of Southeast Asia is held back by corrupt relationships between politicians and businessmen. This results in too many monopolies and cartels, and a corporate sector that enriches a few powerful families at the expense of the overall economy. Under Marcos, crony capitalism plumbed new depths of larceny and incompetence. Still, the situation was bad in the Philippines even before then. This perhaps reflects two things. First, the key business families are also the key political families, rather than their associates, and so are even closer to the heart of government. Second, its history as a Spanish colony means its systems are closer to those of Latin America than the rest of Asia, which was mostly colonised by Britain, France and the Netherlands. So it shares many of that region’s governance problems.”- Cris Sholto Heaton Should you invest in the Philippines?

So how will the present turn of events impact Philippine markets?

Here is how the Wall Street Journal sees the effect of the Euro’s bailout on Asia[1], (bold highlights mine)

``While Asian markets welcomed the €750 billion ($955 billion) bailout plan, economists and analysts warned that the rescue package could end up bringing even more capital to Asian markets...

``Loose monetary policy in Europe and the U.S. has already helped to inflate assets prices in Asia, especially for emerging-market bonds and real estate. The European Union proposal telegraphs that easy money will continue for the time being. The Federal Reserve reinstalled currency-swap lines that will also make dollars more easily accessible to funding markets around the globe.

``Recent data confirm that Asia's economies are moving strongly despite the turmoil in Europe, and are at risk of inflation grabbing hold.

Why should foreign money come to us?

Aside from the tremendous liquidity, Asia’s finances are generally better positioned relative to developed economies (see figure 6)

Figure 6: Money Week Asia[2]: Why the eurozone crisis won't rattle Asia

In relative terms, Asia has higher savings, current account surpluses, low systemic private sector debt, lower national debt as % of GDP and better fiscal position.

I think the most important factor driving Asia today is the inclination towards more openness to trade and investment with the world today. This is aside from deepening trends towards regional integration.

Moreover, the other notable impact of the trade openness is the economies of scale from Asia’s huge population.

However, economic development and financial markets can disconnect as it did in 2008.

So I am not as confident of a decoupling until we see more elaborate evidences from this.

Nevertheless since markets as unlikely to crater from our perspective, the other potential impact could likely come from the optimism brought about by a Presidential honeymoon cycle.

As we noted in the past[3], the Presidential elections in the Philippines tend to coincide with the troughs in the interest rate cycle in the US.

This we think has fuelled the optimism that led to previous Presidential honeymoon cycles (see figure 6). And we seem to be in exactly the same position as before.

Figure 7 Phisix: The Phisix’s Presidential Honeymoon Cycle

The outperformance of the Phisix relative to global markets of late could already be a sign of liquidity driven Presidential honeymoon cycle.

But one week does not a trend a make.

Therefore we will have to observe how our markets will react to external pressures.

Nevertheless the odds appear to be greater for the domestic honeymoon cycle to playout as it has, possibly this time with a stronger impact.

However it’s mainly not because of the election winner, although the buoyant sentiment will indeed contribute, but it’s going to be because of the unprecedented scale of liquidity, given the current conditions.

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[1] Wall Street Journal, Asia Fears Flood of Capital Risks More Overheating

[2] Money Week Asia Why the eurozone crisis won't rattle Asia

[3] See Why The Presidential Elections Will Have Little Impact On Philippine Markets

Asia’s Policy Arbitrage, Phisix And The Bubble Cycle

``There is room for investors to start celebrating ‘neither too hot nor too cold’ again, when they stop fretting about tightening and before they start worrying about bubbles again…All roads still point to an asset bubble in China, most particularly if the currency’s appreciation continues to be suppressed.”-Christopher Wood, CLSA (Bloomberg)

The recent Fed’s action had not been well taken by Asian markets.

Although Asia’s markets had been up for the week, they have immensely underperformed their regional and emerging market counterparts.

It looks as if Asian markets may have overestimated on the impact of the US discount rate hikes and may equally underestimated the Fed’s future actions.

Figure 4: Stockcharts.com: Discount Rate Troubles?

The fall of Asian markets, including the Philippine Phisix (main window), Japan’s Nikkei (Nikk) and Dow Jones Asia ex-Japan (DJP2) seem to coincide with the Fed’s ‘surprising’ announcement.

Perhaps it maybe just an excuse to retrench or perhaps there could be other factors involved. The week long absence of China’s market, which celebrated her Lunar New Year of the Tiger, may have also been a factor.

Nonetheless, surging commodities prices appears to have turned the tide for the Baltic Dry Index (BDI) an index which tracks shipping prices for dry goods. As for the latter’s sustainability, this has yet to be confirmed over the coming sessions.

Our guess is that if China’s markets have indeed bottomed as we suspect it has [see last week’s A China Bubble Bust Is Unlikely Yet], then the BDI index we suspect will rise in congruence to rising key stockmarkets worldwide.

Since China’s markets has recently shrugged off the recent second round of increase in reserve requirements for her banks, her markets may have begun to digest the “exit” strategies employed by their local central bank.

For us, Asia and emerging markets are likely to be more receptive to the incentives brought about by the steep yield curve to keep asset prices afloat than to developed economies.

So it seems a bizarre reaction that we read from a local official of our domestic central bank, the Bangko Sentral ng Pilipinas, to extol on the Fed’s increase of its discount rate as helping out local policies by “narrowing of the [interest rate] spread”, “this gives us [BSP] additional space before we implement our own exit plan” said BSP Deputy Governor Diwa Guinigundo.

Figure 5: Asian Bonds Online: Steep Yield Curves

Mr. Guinigundo doesn’t seem to realize that local inflation will likely speed ahead of the US given the domestic market’s likelihood to respond better to low interest (see figure 6), the El Nino problem which will likely aggravate the looming shortages of our agricultural produce already hampered by last year’s Typhoon Ketsana nickname Ondoy and Typhoon Parma nickname Pepeng, and compounded by rising oil prices in the global market.

These factors, which weigh heavily on our local CPI, would likely pivot up the domestic interest rates ahead of the US, perhaps as soon as the local elections are concluded in May.

The basic flaw is to read Fed’s policies as oversimplistically linear, as the case is with most of the practicing aggregatists which tend to pick on select variables to highlight on their desired outcome.

We can’t entirely blame Mr. Guinigundo since as one of the leading technocrat for the banking sector, media publicity demands for “simplistic” replies.

By looking at the internal dynamics of the Phisix as potential measure of capital flows, the past two weeks has seen some substantial inflows from foreign funds. These inflows have been coincidental with the dramatic surge of the Phisix following the “Greek and China” myth induced meltdown during the prior weeks.

Yet compared to the 2003-2007 boom, where foreign funds constituted the bulk of the trades, today’s market attribute reveals the opposite local investors dominate trade.

But given the inflationist approach by major economies in dealing with their local predicament, it isn’t far fetched that the “widening” spreads [and “devaluing” foreign currencies] from which our domestic central bankers seems concerned of may come to fruition (see figure 6).

Figure 6: Money Week Asia [UBS]/ Wall Street Journal: Who Wins In A Liquidity Bubble/Private Capital Inflows

And considering the underdeveloped and relatively small state of the Philippine Stock Exchange, a larger than usual foreign inflow can virtually exaggerate returns that could turn the Phisix into a full blown bubble as it had during the 1987-1994 chart (left window).

Phisix 10,000? That should be peanuts compared to the returns then (the Philippines and Indonesia had nearly 1,000% gains while Thailand had 800%. Argentina and Mexico had even an astounding 1,400% gains-all in US dollar terms.)

It isn’t likely that past performance would exactly repeat, but as shown in the right window, foreign capital flows into emerging markets appear to be accelerating anew and they may contribute to enhanced returns based on global policy arbitrages.

And it is also why the IMF has reverted to its interventionist tendencies and has recently prescribed capital controls for emerging markets, ironically aimed at curtailing inflows. This is in sharp contrast to the past where it recommended capital controls to prevent outflows.

Times have indeed changed.

So while many seem to fear for a reprise of 2008, a dynamic which we see as a remote possibility since most of these fears appear to be predicated on Posttraumatic Stress Disorder (PTSD) [see What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?], we see that excess reserves and the inflationist proclivities of developed economies in dealing with their fiscal woes as risking a supersized global inflation or serial bubble blowing in Asia and or in emerging markets.

In short, while many fear a meltdown, I am concerned of a meltup.

Finally, if gold surpasses its resistance at 1,120-1,125, it is likely that global markets will continue moving against a wall of worry or continually move uphill. This ascent will especially be stronger if both the US and China’s markets chimes in.

Divergence, Momentum And China's Historical Patterns

``As a general rule, the public believes economic conditions are not as good as they really are. It sees a world going from bad to worse; the economy faces a long list of grim challenges, leaving little room for hope. We can call this the pessimistic bias, a tendency to overestimate the severity of economic problems and underestimate the economy’s performance in the recent past, the present, and the future.” Bryan Caplan The 4 Boneheaded Biases of Stupid Voters

A short discourse on the present market activities and momentum.

One odd development is that while Europe has belabored on Greece’s credit standings, where her CDS premium has run amuck, Europe’s stock markets appears to have diverged from Asia. Europe appears to have suffered lesser degree of losses, this week, in spite of the fears of a protracted crisis which risks a contagion.

In other words, in Europe the credit markets and equity markets appear to have decoupled. Yes I know, experts will assert that credit markets are smarter than the equity market counterpart. But past performance may not guarantee future outcome. Aside, market risks appear to have shifted to Asia. That’s based on this week’s activities.

Importantly even as most of the major European economies absorbed losses, the losses haven’t been broad based, as some nations like Norway, Denmark, Finland, Belgium and even the crisis stricken Greece (!!) managed to register modest gains. Moreover, the frenzied bullmarket momentum in some of the Baltic States and that of other parts of Eastern Europe remains streaking hot!

Greek Tragedy Or Comedy?

So the market and opinion pages have not been saying the same.

An analyst recently commented that austerity won’t be popularly embraced in Greece which risks political chaos. Perhaps. But it doesn’t mean that it shouldn’t be done. If a person ails, no matter how bitter the medicine or how inconvenient the treatment, these will have to be taken if the preference is to expect a recovery. To add, regardless of the choice inconvenience will prevail during state of ailment. But we aren’t talking of a person but of a nation state called Greece.

Hence, the issue isn’t about austerity. The issue is about austerity or reforms aimed at recovery under an independent Greece or under the wards of the European Union.

Yes, the Union may have to bend legal rules from the Stability and Growth Pact and may have to face the risks of moral hazard or a chain effect of bailouts among member nations, but as we have written, politics will govern. Politics that would encompass the preservation or the disintegration of the Union, where the direction of policies will likely buttress the former in spite of the costs of bailouts even at the risks of future dismemberment.

It’s rare to see officials to take on policies that have long term impact, as this would defy public choice economics, where actions of policymakers are most often associated with reelection goals.

Besides, austerity programs will likely undermine the socialist government of Greece, which should translate to a long term positive.

Yet a naughty part of me is toying with the idea that perhaps the Greek episode is being deliberately prolonged so as to extend the decline of the Euro against the US dollar.

In a world where everyone seems to hanker for a devalued currency, out of the prevailing mercantilist tendencies by global officialdom, a market based decline predicated on such adverse development, without intervention, could be part of the tactical operations. Could ECB’s Jean Claude Trichet be snickering behind the scenes?

Market Momentum And Will China Repeat Historical Patterns?

Many markets have broken trend channels (e.g. Euro and gold) or is situated at support levels (e.g. China’s Shanghai), this means that assuming market momentum persists without the interference from officials, then momentum suggests that for the interim, these markets could suffer from an extended malaise. Let’s be clear, no bubble bursting here.

Although, since some markets have technically been in oversold conditions, a bounce could be in the offing, perhaps by the coming week. However, the mid term momentum will likely translate to 1-2 months of consolidation (or downside) before a renewed upside.

In addition, in the US markets, as measured from the futures market, weak hands appear to dominate which further implies disappointments, according to the Danske Team ``The equity market is filled with investors who do not believe in holding equities long term, but who instead trade equities hoping mainly for a quick profit. This is reflected in e.g. the number of long speculative positions as a share of total open interest in the S&P500 futures market. Contrary to the norm, long speculative positions now account for 15% of total positions (down from 20% two weeks ago), something not seen since summer 2002. At that time the market corrected sharply, reflecting that the tech bubble had not fully deflated. Last week’s negative focus on the necessary Chinese and US tightening measures is thus probably a warning that equity investors collectively have little tolerance of disappointments, and that expectations for the global economy in 2010/11 have risen too high.”

Again this speaking from the context of market momentum in the assumption that markets will be left alone to operate by authorities.

Figure 8: BCA US Global Investors: History Rhymes?

Finally, this is an interesting set of charts on China’s markets, all of which illustrates how China’s market has endured from tightening concerns and how they responded after.

In the past two occasions 2003-4 and 2006-7, interim weakness eventually paved way for stronger markets. Today we are seeing the same phase of weakness.

According to US Global Investors, `` While the recent correction in China has been steep and swift, history suggests buying opportunities in the medium term. In early 2004 and early 2007, when tightening fears haunted investors in a policy environment similar to the current one, Chinese stocks underwent a sharp selloff for a couple of months and yet finished the year higher as investors realized the economy was not headed for a hard landing.”

In my view, in going against James Chanos, I’d say that China’s has ample room to inflate! And today’s weakness is a buying opportunity as the BCA chart suggests.

To be clear, it’s wrong to interpret a bubble to mean a peak of the cycle! Instead, Bubble is a process characterized by a boom followed by a bust.

Bill Gross: Beware The Ring Of (DEBT) Fire!

Here is PIMCO's Big Boss Mr. Bill Gross who makes the case of HIGH DEBT-LOW Growth and LOW DEBT-HIGH Growth investment theme...

They can be broken down into 2: For risk assets-select Asia and emerging markets and for less risky fixed income assets low debt developed nations.
Here is Mr. Gross: (bold emphasis his)

1. Risk/growth-oriented assets (as well as currencies) should be directed towards Asian/developing countries less levered and less easily prone to bubbling and therefore the negative deleveraging aspects of bubble popping. When the price is right, go where the growth is, where the consumer sector is still in its infancy, where national debt levels are low, where reserves are high, and where trade surpluses promise to generate additional reserves for years to come. Look, in other words, for a savings-oriented economy which should gradually evolve into a consumer-focused economy. China, India, Brazil and more miniature-sized examples of each would be excellent examples. The old established G-7 and their lookalikes as they delever have lost their position as drivers of the global economy.

2. Invest less risky, fixed income assets in many of these same countries if possible. Because of their reduced liquidity and less developed financial markets, however, most bond money must still look to the “old” as opposed to the new world for returns. It is true as well, that the “old” offer a more favorable environment from the standpoint of property rights and “willingness” to make interest payments under duress. Therefore, see #3 below.

3. Interest rate trends in developed markets may not follow the same historical conditions observed during the recent Great Moderation. The downward path of yields for many G-7 economies was remarkably similar over the past several decades with exception for the West German/East German amalgamation and the Japanese experience which still places their yields in relative isolation. Should an investor expect a similarly correlated upward wave in future years? Not as much. Not only have credit default expectations begun to widen sovereign spreads, but initial condition debt levels as mentioned in the McKinsey study will be important as they influence inflation and real interest rates in respective countries in future years. Each of several distinct developed economy bond markets presents interesting aspects that bear watching: 1) Japan with its aging demographics and need for external financing, 2) the U.S. with its large deficits and exploding entitlements, 3) Euroland with its disparate members – Germany the extreme saver and productive producer, Spain and Greece with their excessive reliance on debt and 4) the U.K., with the highest debt levels and a finance-oriented economy – exposed like London to the cold dark winter nights of deleveraging.

Of all of the developed countries, three broad fixed-income observations stand out: 1) given enough liquidity and current yields I would prefer to invest money in Canada. Its conservative banks never did participate in the housing crisis and it moved toward and stayed closer to fiscal balance than any other country, 2) Germany is the safest, most liquid sovereign alternative, although its leadership and the EU’s potential stance toward bailouts of Greece and Ireland must be watched. Think AIG and GMAC and you have a similar comparative predicament, and 3) the U.K. is a must to avoid. Its Gilts are resting on a bed of nitroglycerine. High debt with the potential to devalue its currency present high risks for bond investors. In addition, its interest rates are already artificially influenced by accounting standards that at one point last year produced long-term real interest rates of 1/2 % and lower.

End quote.

One last noteworthy quote...

"the use of historical models and econometric forecasting based on the experience of the past several decades may not only be useless, but counterproductive."

What’s The Yield Curve Saying About Asia And The Bubble Cycle?

``What is being ignored is the more fundamental question of whether the Fed should be attempting to set or influence interest rates in the market. The presumption is that it is both legitimate and desirable for central banks to manipulate a market price, in this case the price of borrowing and lending. The only disagreements among the analysts and commentators are over whether the central banks should keep interest rates low or nudge them up and if so by how much.” Richard M. Ebeling, Market Interest Rates Need to Tell the Truth, or Why Federal Reserve Policy Tells Lies

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.