Yet I suppose what seems to us confusion
Is not confusion, but the form of forms,
The serpent’s tail stuck down the serpent’s throat

– Robert FrostA Masque of Reason

Robert Frost’s vivid image of the Ouroboros signified to him the symbol of eternity, but also the way things came around. Thus it is that financial markets, recovering from the worst leverage crisis of the past century or so, have undertaken another round of borrowed money in what appears a futile attempt to achieve escape velocity from the debt swamp.

The problem with defining an asset bubble in the current markets isn’t so much a question of level, that is the prices at which assets are traded, but rather the source of funding for investors who have been buying the particular asset. Essentially, what makes a bubble is leverage, borrowed money that helps to egg on prices far above what is suggested by fundamentals.

Sitting on the sidelines, a recent article from my Asia Times Online colleague, David Goldman, on the most recent “carry trade” pronouncement of celebrity economist Nouriel Roubini makes for interesting reading. First the relevant, offending, bits of Roubini’s statement as carried in a trading blog:

Let us sum up: traders are borrowing at negative 20% rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70% range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments, is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

Goldman’s response:

Roubini is an academic economist who doesn’t know a bubble from his – well, never mind. There is no evidence that the world is borrowing money to buy equities. American assets have gotten cheaper, American companies earning cash flows in foreign currency or producing international tradables are worth more – and that’s it. Now, I think stocks will fall from present levels for a number of reasons, but that is not a collapsing bubble.

Bubbles are created through leverage. There are plenty of worrying applications of leverage, for example, the Private-Public Investment Partnerships [in the United States] that have levered up distressed structured securities a dozen times, and goosed up the price of what used to be called toxic waste. I described this as a mini-bubble toxic waste which contributed to high “trading profits” during the third quarter. My recommendation was to sell the banks.

In my mind, there is disconnect between the overall systemic leverage that Roubini probably (to be charitable to him) has in mind and the absence of a causal trading link that Goldman establishes in his blog.

Let us look at oil versus the dollar. Assume that you are a big Chinese company that needs to purchase crude oil for the next few years. Thanks to extremely loose monetary policy at home (a function of China allowing its banks to lend unlimited amounts of money from the beginning of this year), you can borrow now to purchase more stock than you need for the coming six months – say that if you believe prices will go up, and therefore purchase 18 months worth of stock.

So the leverage is at the Chinese company and is used to purchase three times the physical oil as what would have happened the previous year. Now, track this through the system:
a) Chinese company borrows money, and sells yuan to purchase US dollars.
b) It buys three times as much oil as normal, and uses the dollars to pay for it.
c) The London trader receiving the US dollars sells it in the foreign exchange market, to buy more oil (in order to replenish his stock).
d) The oil company that sells to the London trader and receives dollars now decides to sell dollars and buy US stocks.
e) The pension fund that sold stocks to the oil company decides to use its increased cash position to buy more stocks.

In terms of price impact, the above trajectory would mean that oil prices go up, the US dollar goes down and US stocks rise in price. Right there, you have the correlated relationships that Roubini talks about between the US dollar and stocks, but the causality is the leverage taken in China, not the US. There is no “carry trade” here, merely a circular flow of speculative money that was initially funded by a monetary expansion in one country.

Look at another scenario, this one from 2007 involving Todd the baker in New York. Todd was doing quite well on his bakery, and used a loan from the bank to add new equipment in 2007. Additionally, Todd has a 75% mortgage on his flat in Manhattan as well as a 90% mortgage on his vacation home in Florida. Between the mortgage payments and his monthly income as baker, Todd about breaks even and had around US$100,000 of stocks. As a footnote, both his mortgages were reset with “Option ARM” (adjustable rate mortgage) from his local bank; his mortgages are among the hundreds packaged and sold to a Chinese bank in 2007. He got a good deal in 2007, but faces a sharp rise in payments from 2010 when the mortgages will be reset.

So what happened to Todd from 2007? His home in Florida fell by 40% in price terms, while the one in New York is down 15%. He lost half his stock value in 2008 and decided to sell and retain his $50,000 at the end of the year. His bakery is suffering as customers purchase less expensive bread varieties, making his new equipment basically useless.

For Todd, the reduction in interest rates from the Federal Reserve to basically zero has meant that his mortgage payments have stabilized at lower levels. He cut a lot of monthly expenses to become barely cashflow positive, but once he saw stock prices going back up in April this year (and watching the pension fund in the above example buying more stock – at least that’s what the nice lady on CNBC says), Todd started buying some that helped to create about $20,000 of profits for him this year.

So what is wrong with this picture – here you have the example of a deeply leveraged consumer who instead of using available cash to reduce his debts or service payments has used it to increase his risk by purchasing stocks. His leverage, though, has no causal link to the decision to purchase stocks, in the sense that Todd isn’t borrowing money from the bank to purchase stocks – but there is a clear issue of behavioral finance, namely an attempt to speculate in the stock market in order to pay down his losses on mortgage debt.

Don’t be too scandalized by Todd’s behavior; it is simply the retail version of what the biggest banks are doing – as Goldman highlights in his blog entry.

What exit strategy?

In highlighting the continued risks to the global economy, various central banks this week downplayed suggestions of any changes to monetary stimulus (and presumably, their host governments would do the same on the fiscal side):

  • The Federal Reserve left rates on hold and also mentioned that its policy of low rates will continue for the foreseeable future.
  • The Bank of England kept rates constant and increased its target for quantitative easing to 200 billion pounds (US$332 billion – money that will be used to purchase UK government bonds).
  • The European Central Bank (ECB) kept rates on hold and also mentioned a gradual approach to removing stimulus funding (code for keeping emergency measures in place for a little while longer). While the Federal Open Market Committee “continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period”, ECB president Claude Trichet said that “concerns remain relating to a stronger or more protracted negative feedback loop between the real economy and the financial sector”. In effect, the notion that central banks will become more responsible with respect to inflationary pressures being suggested in commodity prices and the slow decline in Asian confidence with respect to fiat currencies (witness India’s decision this week to purchase some $6.6 billion of gold rather than US Treasuries) was belied by this week’s statements. As a last signpost here, it is appropriate to look at the trading levels of the broad market sentiment indicator, called the VIX (short for Volatility Index). Rising volatility suggests greater nervousness, and falling volatility suggests increased confidence; the long-term average of the index is less than 20 (as markets usually rise more than they fall). Last Friday (October 30), the index started at 25 before jumping through the day to close just over 30. That significant jump in the volatility index was followed by another roller-coaster day on Monday where the index fell to 28 before rising back to 30. The index fell for the next two days, closing on Wednesday at just under 28. These kinds of whip-saw moves in stock market volatility indicators suggest not just an elevated level of nervousness but, more importantly, the leveraged nature of losses filtering through the system should asset prices decline once again. That leverage will come back to sink the asset markets should central banks ever gain the confidence to raise rates and cut quantitative easing strategies, as is being suggested. The bigger risk from this week is that even if the big three central banks don’t move on rates, other central banks – especially those in Asia – may choose to follow India’s example and cut their holdings of G-3 (US, euro and yen-based) financial assets; a development that will increase global interest rates and cause unparalleled declines in asset values. I close with another quote from Robert Frost, this time a poem called The Bearer of Evil Tidings: As for his evil tidings,
    Belshazzar’s overthrow,
    Why hurry to tell Belshazzar
    What soon enough he would know