Feels Like 1997

Just back home after a week-long road trip to many major U.S. cities.

The “Cranes Of Dubai” 

As an economist, I am always looking for anecdotal evidence of how the local economy is doing.  What impressed me most was the ubiquity of building cranes, which usually symbolize a top, or closer to, the end of a cycle, than a bottom

At the peak of the building boom in 2006, the apocryphal statistic that Dubai had between 15 and 25 per cent of the world’s tower cranes was widely reported. Some said there could be as many as one tower crane for every 44 residents. But industry experts say that while such “facts” made good headlines, they were unlikely to have ever been true.   – The National

Other Observations:

  1. Surprised at the poverty of seniors in New England.  Most of the cashiers in retail were closer to 80 years old than 40 years old.  My friends tell me one factor is simple demographics. Maine, for example, is the oldest state in the country;
  2. Spending across all cities seemed robust;
  3. You can feel and almost slice the faux wealth across the board;
  4. Prices everywhere are absurd, such as $2.50 for coffee refills and rents in NYC.  Not sustainable;
  5. Gas is 20 percent cheaper on the east coast than in California. Always the case due to different standards and higher taxes;
  6. Visited the country’s new rust belt — i.e., Manhattan retail. It is genuine. Stunning to see 3 out 4 storefronts empty in my old West Village neighborhood,
  7. America is a great country and draws its strength from her diversity, from the beautiful young woman, an Albanian immigrant student, who checked us in at Hertz at Logan, to our Uber driver from Ukraine at SFO.

We will have more on the trip later.

Turkey

Greg Ip published an interesting piece in the WSJ,   On Turkey, Another Step in the Weaponization of Global Finance,

Trade wars may be morphing into something more dangerous: financial wars.  – Greg Ip

It channels our thoughts from the post from the road, Watch Turkey

Do U.S policy makers go the traditional route of trying to stabilize the situation through IMF, etc., or is it politics uber alles?    Does the Trump administration instead step on Turkey’s throat?

We may be witnessing the end of globalization.  – GMM, August 12th

It’s Not The Dollar, Stupid!

We find it hilarious to watch the market pundits pin the recent turbulence in markets on a rising dollar.  Complete nonsense.

The trade-weighted broad dollar index is about back to where it was on 2016 election day.  The dollar is a symptom and recipient of capital flows due to the weak fundamentals driving the turmoil in the emerging markets and also U.S. monetary tightening.

Dollar_Aug15

We concede the recent strength of the dollar is a suitable indicator species that something is amiss in the global economy but does the discovery of a four-headed frog in Minnesota, for example, cause a changing ecosystem or is it just a reflection?

Some countries with poor initial conditions at the beginning of quantitative tightening in the U.S. (and coming to Europe sometime soon) monetary policy, which is unique and has never been attempted in the history of the modern currency system, are ill-prepared  for this unprecedented financial undertaking.

External and internal imbalances, political instability, and too much debt are toxic in a tightening monetary environment.   Argentina and Turkey were the first to blow.

Tighter Money

The Fed has reduced its balance sheet by about $200 billion since October 2017.   Nobody knows for sure the impact on “global liquidity” — an elusive concept similar to the term “contagion” —  or can write a model of differential equations to measure the consequences of such a rapid and large reduction in base money.   Only, at best, calculated guesses.

Bonds_SOMA_Portoflio_Total SOMA

We do know, however, it is starting to bite.  Emerging markets and commodities are the first to feel the impact of tighter global liquidity.

Feels Like Asia 1997

Ron Insana read our mind with his tweet this morning.

The timeline of what we are seeing feels much like how the 1997 Asian Financial Crisis unfolded.

The U.S. economy was also very strong but other financial conditions were different back then.  The Fed had hiked once in April 1997 and stopped in May.  Chairman Greenspan was worried about ‘irrational exuberance” in the U.S. equity market.  He was eventually correct but 3 ½ years too early.

The Asian “Tiger economies,”  Thailand, Malaysia, Indonesia, the Philippines, and eventually, Korea, experienced significant balance of payments crises.  See here for a good history.

Contagion

The crisis spread around the world and sowed the seeds for the Russian debt default and LTCM crisis in 1998.   We were sitting on a trading desk at the time and experienced first hand how financial contagion spreads like a pandemic.

We had warned investors to watch the Hang Seng index as it was in meltdown mode while the bonds of the rest of the emerging markets x/ Asia were making all-time low credit spreads.  We were also worried about Korea, which was relatively unscathed by the first round of turmoil that hit Asia in the summer.

Korea

Korea was exposed with a large stock of short-term debt, mainly interbank and trade lines to Japanese banks.  We were fortunate to work with one the best Japanese bank analysts at the time who would brief us on a daily basis.  The large Tokyo banks had to shrink their balance sheets due to losses in Asia and the falling Nikkei index to maintain adequate capital ratios.  We calculated the easiest way to do so was to allow their interbank lines to roll off in Korea.

The U.S. and European banks saw the Japanese banks getting out, and also headed for the exits as they didn’t  want to be the last holding the bag.   The Korean central bank was in the market almost every day selling dollars and hard currency to fund the redemptions and cushion the blow to the currency.

Korea’s reserves fell to a level that set off a panic that the government could not repay its own borrowings.  We never worried about a sovereign default and predicted Korea would “carve out” enough reserves to fund government debt service by selectively defaulting on other claims on the country.  That is exactly what Korea did:  restructuring the commercial bank debt.

Spread To Latin America And Beyond

As the Korean banks suffered a liquidity crisis, they were forced to sell assets to pay their interbank lines coming due.  They were big sellers of Brazilian bonds, which drove the price down, forcing Brazilian banks to sell their holdings, and raise additional liquidity by, say, selling their Russian debt.

We walked in one morning, and the Hang Seng was down almost 10 percent on the day.  The very day before, the EMBI, an index of dollar-denominated EM sovereign debt,  closed at a record tight spread over U.S. Treasuries.   A mass liquidation began, and if we recall correctly, some Brazilian bonds fell over 20 points that day.

This is a simplistic explanation and, of course, it was more widespread, complicated, and complex, but this is how contagion and panic spreads, folks.   Market psychology then takes over, and it’s game on.  Enter the dragon – a full-blown global financial crisis.

An external stabilizer with deep pockets, such as the IMF, and a credible economic program and plan becomes essential to restore confidence.  Even then, it takes time for the markets to believe the plan and commitment of policy makers are credible.

Are We On The Eve Of Another 1997?

We don’t know, but the current situation merits close attention and concern.

Today feels more like a combination of the 1995 Mexican Peso Crisis, which was triggered by the tightening of U.S. monetary policy,  Asia 1997, and the Russian Debt default, which was a local currency debt crisis, coupled with moral hazard and politics.

What Worries Us Most

The Trump administration has a weak economic bench, in our opinion, which doesn’t have the credibility and confidence of the international financial community as the Committee To Save The World – Alan Greenspan, Robert Rubin, and Larry Summers – did.

Mnuchin_Aug15

 

Committee To Save The World_Aug15

 

The Clinton administration had a deep economic team and confidence of the global markets, regardless if you agreed with their policies.  They even dispatched the little known Timothy Geithner to negotiate the stabilization programs in Asia.

Add Stanley Fischer, who was essentially running the show at the IMF at the time,  and Terrence Checki at the New York Fed, and the international financial community had the murderer’s row of economic policy makers during the late 1990’s financial crises.

POTUS

Furthermore,  we are not sure what side the POTUS is on.

Is he a short seller of the countries who are at odds with his administration’s trade and other policies?  Will he step on the throat of those emerging markets if they begin to go up in flames?

With Turkey facing a currency crisis, President Trump last week poured fuel on the fire by doubling tariffs on imports of its steel and aluminum to offset the effects of its weaker currency or force the country to release an American pastor. (Mr. Trump’s motive remains unclear.)

In the hierarchy of things afflicting Turkey, this isn’t that high: The country’s problems are mostly self-inflicted, from its large current-account deficit and steep dollar debts to the politicization of its central bank.

But it is the latest example of how the U.S. and other countries are weaponizing international finance in ways that could destabilize the global economy and fray the intricate web of relationships that sustain it.

While trade wars aren’t good for growth, rarely do they induce a recession, or even a noticeable slowdown. The infamous Smoot-Hawley tariff of 1930 was at most a minor contribution to the Great Depression. By contrast, there’s a long record of international financial disruptions fueling economic stress, from the Depression to the bankruptcy of Lehman Brothers nearly 10 years ago.  – WSJ

One Last Thing

We were market makers during the 1997 Asian Crisis.   Where are the market makers today?   Gone, gone, and gone.

The liquidity for those looking to get out if a full-blown crisis does erupt will be horrendous.   Just look to the recent events in Italy and lack of liquidity in one of the world’s largest bond markets.

The conditions for a perfect storm are in place.   We are not claiming it is inevitable but it is a higher probability than currently being discounted and should be on everyone’s radar.

Stay tuned.

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