In both the case of Bear and
Lehman, few could have predicted at how fast the Wall Street giants could
collapse when market confidence in these firms evaporated. Is the US any different? Can world markets wake up
tomorrow and decide that US imbalances, leverage and now monetization are no
different than Bear and Lehman mortgage market exposure and leverage that
brought these firms down.
To some extent the US is vulnerable to a run on its currency and assets
much as highly leveraged and undercapitalized investment banks were to their
exposure to bad mortgages, real estate and highly toxic credit
derivatives. But one day of selling of the dollar, stocks and bonds does
not make a market run on the US. A sovereign run is a tip of the tail event
for a large industrialized and diverse economy like the US. Anything is possible and some things are like
a collapse in US assets and the dollar should not be ruled out in light of the current
budget math, growth outlook and dependence on foreign capital. But this
does not make a run probable.
It seems to me there is some
credit risk being priced into the dollar and bonds and this has been a risk for
some time. But pricing in some risk US loses its AAA rating to AA from highly discredited
credit rating agencies, is not the same as pricing in WeimarRepublic or Zimbabwe outcome for the US.
Still because US imbalances
are so large and Fed and Treasury policy all in on credit and demand, there is
not a lot of room to maneuver for US asset prices, the dollar, the policy
response and the real economy without creating undesired disorderly adjustments
in capital markets. Thursday was borderline disorderly and surely put US officials into an elevated state of alert.
So today when only bonds and
the dollar are getting crushed we can breathe a little easier.
Still we should see more
scope ahead to price in credit risk for the US and see declines in the dollar, stocks and bonds and
this leaves open the chance of episodes of disorderly adjustmentsâ€¦just not the
end of the world as we know it.
What seems to be happening,
however, is a change in the narrativeâ€¦what makes markets do what they do
(regardless of the reasoningâ€¦faulty reasoning has the capacity to drive
financial markets and currencies far longer than most anyone can stay in a more
rational trade). The narrative change seems to be exiting risk-aversion
theme for sovereign risk theme.
If I had to break down where
markets have been in terms of key themes or narratives since the credit crisis
unfolded and morphed into an economic crisis I see three distinct phases.
The first and longest lasting was the life or death of capitalism period when
the banking system verged on self-destruction on at least two occasions â€“ after
the failure of Lehman in the fall of 2008 and in early March in the stock
market capitulation low. This phase was largely about avoiding risk and
covering exposure (huge net dollar exposure as it turned out). Get fetal,
get cash (USD) and stay alive. The second phase was policy-related â€“ now
that policy makers avoided a collapse in the system by underwriting weak large
banks too big to fail, the focus shifted (narrative changed) to how can
officials get banks and the real economy going again. This period, where
risk aversion also reigned supreme in pricing assets and FX, focused mainly
around the credibility of the policy response â€“ deeply questioned to the near
demise of equities through early March as the Obama administration struggled to
get its arms around the crisis with the help of a suddenly highly doubted new
Treasury Secretary Geithner. The third phase is one where the
administration has responded forcefully if not smoothly and succeeded in
turning sentiment in favor of recovery and the survivability of the banking
system (no one is even talking about bad bank assets and PPIPâ€¦it is assumed
that the patient has survived and faces uncertain rehab ahead). In this
phase the markets are questioning the exit path. How does the US Treasury
and Fed unwind some $12trln in cash and insurance thrown at the problem get
unwound without seriously damaging if not killing the dollar, Treasuries and
the economy/stocks? Will this buy a sustainable recovery in the
real economy that supports earnings and incomes ahead? This new phase is
not primarily a risk aversion trade. Indeed the more perceived US sovereign risk, the lower US assets and dollar. In the prior two phases
elevated risk saw capital run to dollars and Treasuries (and out of
equities). I suspect the days of blind risk aversion-based trading
are over and the new sovereign risk world is here and tied directly to a post
crisis exiting of massive stimulus that pose great risks to US debt, equity and
I can see in fairly short
order markets beating a new drum in Washington not unlike the one they beat in
January-March â€“ tell us what your thinkingâ€¦what is your exit plan Mr Fed and Mr
Treasuryâ€¦we want details and soon!
Sadly the success of getting
the real economy back into the leading role in the economy and replacing the
government depends to a great extent on keeping market rates from rising much
more â€“ higher bond yields in due course could prematurely kill the
No one ever said this would
be easy to more or less borrow from Cold Play. Markets have a knack for
disrupting the best made plans of officials. Short of the Fed really
swarming over the bond market more permanently and buying trillions more in
bonds, it is hard to see how the Fed can thread the needle. And the
outcome if they donâ€™t thread the needle? A lost decade.
Markets are being rewarded
for pressing bets on the Fed and Treasury not getting it right and the lost
decade the more likely outcome. Going back to the days of risk aversion
seems unlikely from here. Supply, anemic recovery, structural imbalances,
household and firm (banks especially) balance sheet adjustments, absence of
exit strategy details and sovereign rating risks are what will dominate
thinking ahead and these stack up at this early stage of the new phase as
decidedly bearish for US Treasuries, the dollar and stocks. There is
plenty of downside to price in between where we are today and a WeimarRepublic or Zimbabwe outcome.
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