Changes on the Margin
By Frank Barbera CMT. February 20, 2007
While no two business cycles are ever the same, the dynamics in this credit cycle has been unlike any cycle ever seen in this country's, or for that matter, any country's history. The shear size and scope of today’s credit and monetary figures, bandied about in hundreds of billions and trillions of dollars, ends most quantitative comparisons dead in their tracks. To this end, it has been the ever abundant ‘sea of liquidity’ that has buoyed up stock markets, forced down long-term interest rates, and moved the financial economy to the fore. And never before has the Fed been forced to walk such a high wire balancing act, trading off ‘Dollar Stability’ against the frightening backdrop of exploding trade imbalances, with ‘Credit Market stability’ and the insatiable need to keep credit availability high, and the cost of funds down.
Will the Fed go one tightening too far and cause the credit markets to unwind, yielding another financial accident of the Amaranth Advisors or LTCM variety? Or will the Fed delay easing too long, denying a monetary rescue to the thousands of homeowners desperately in need to lower rates? It is a perilous high wire act hinged on the good will and confidence of foreign capital — this, in a world of combustible geo-political issues. War in the Middle East, increasing nationalistic competition over scarce natural resources, globalization and its endemic protectionist trade issues, the age of overt state sponsored terrorism incorporating the nuclear issue, with the nuclear issue the devolution of MAD and the rise of ‘Plausible Deniability’,-- we live in a world where “confidence” of all sorts, and trust, is increasingly under attack. This is a high-risk condition, and will likely test derivative mechanisms that have never needed to find traction in difficult times before. Under such conditions, confidence can be a fleeting friend, as there is much we do not know, and little we can know for sure. While the daily revolving tickers on cable TV announce new highs in the stock market, for most investors, a good hard look at the surrounding environment would seem to be the order of the day. In this vein, it seems to this writer that things are quietly starting to change.
For example, every quarter, the Federal Reserve Board conducts its Senior Loan Officer Opinion Survey as an indication of lending conditions within the credit system. In my view, at the present time absolutely nothing could be more important as the key aspect of noting a change from Credit Boom to Credit Bust is a change in the perception in the lending environment. In their 1999 study for the American Economic Review, authors Graciela L Kaminsky and Carmen M. Reinhart, “The Twin Crisis: The Causes of Banking and Balance of Payments Problems” analyze the links between banking and currency crisis. In their study of Latin American economies in the 1970’s, they found that severe problems in the banking sector typically precede a currency crisis and that a currency crisis will in turn deepen the banking crisis in a vicious circle. The two point out that a long period of financial liberalization often precedes the preliminary banking crisis accompanied by a long boom in economic activity fueled by credit, capital inflows and an overvalued currency. Sound familiar?
In their study, Kaminsky and Reinhart found that the crisis tends to develop in full blown fashion as the economy slows into recession. It is against this unsavory balancing act that we ponder the implications of the preceding chart which plots the Fed Survey results for the Net Percentage of Respondents Indicating MORE Willingness To Make Consumer Installment Loans. In case you have been asleep under a tree for the last 10 years, consumer installment loans, and consumer spending has been the 800 pound gorilla for the US vendor-financed economy. In this manner, it is extremely disturbing that the cycle between 2002 and 2005, the aptly named Barry Ritholtz’s “Backwards Economy” led by the Real Estate boom, made lower highs than what had been seen in the prior “Jobless Recovery” of the 1991 to 1995 time period. Worse, this figure is heading for negative territory suggesting that confidence is on the wane. Even more alarming is the trajectory seen in a variety of these FRB Survey series. Note the sharp uptick seen in the last data plot in the Loan Officer Survey question relating to the Net Percentage of Domestic Respondents TIGHTENING Standards For Mortgages To Individuals. OK, it is true that we have yet to see a break out to multi-year highs in this series, but with the action of the last few weeks in the sub-prime sector, can that really be very far away?
Above: Tightening Standards For Mortgages to Individuals
As a market technician, what concerns me the most are the trends, and in looking at all of these data series, it becomes highly probable that a cyclical turn has been made in the credit availability cycle. Just look at the next few charts, where we see the Net Percentage of Domestic Respondents TIGHTENING Standards for Commercial and Industrial Loans to Large and Medium sized Firms, clearly rising from below zero, back toward positive territory. Likewise, we see evidence of a building upside reversal in the Net Percentage of Domestic Respondents INCREASING Spreads of Loan Rates over Cost of Funds.
Above: Tightening Lending Standards for Commercial and Industrial Loans
Above: Increasing Spreads of Loan Rates over Cost of Funds
In his book, “Manias Panics and Crashes: A History of Financial Crises” (1978), Charles Kindleberger puts forth the proposition that financial instability can often directly lead to business cycle turning points, a view characterized by heightened “financial fragility” that develops over the course of a particular cycle. Kindleberger and others including Minsky, Kaufman and Friedman viewed crisis and contraction as the inevitable consequence of excess economic booms and held that business cycle upturns were usually triggered by exogenous factors that provide new profitable investment opportunities in key sectors of the economy. “Rising prices and profits encourage more investment and also speculation for capital gain." Much of the process is debt financed, primarily by bank loans which in turn, by increasing the money supply, and deposits, increase the price level. Once a general optimism and euphoria take control, monetary velocity increases and further fuels the expansion with still higher prices encouraging the creation of more debt. The process continues until a general state of overindebtness is reached, and a point at which individuals, firms and banks have insufficient cash flow to service their liabilities. At this point, where credit begins to contract, Kindleberger held that the “financial System becomes vulnerable to a crisis.” In looking back at the credit cycle of the last few years, we see that lenders dramatically loosened credit and underwriting standards, and brought to market a wide assortment of creative credit and mortgage related products, all aimed at making the ‘consumer spending lifestyle’ more affordable. While we are clearly still in the early to middle phases of even a “would be” credit contraction, the trend at the moment appears to be locking on target toward a path whose fallout may be an unstoppable force. In his article entitled, “An Era of Unintended Consequences” Michael Panzner summed things up quite well stating that,
“Designed to facilitate risk-sharing and mitigate the cyclical downside of traditional banking practices, the widespread use of securitization in recent years has been seen as a boon. Instead, it has transformed plain-vanilla credit exposure into a dangerous concoction of credit, interest rate, prepayment, counterparty, timing, and operational risk. The gold rush of modern financial alchemy virtually ensures that all facets of the economy will be adversely affected when circumstances take a turn for the worse.”
Similarly, by allowing hedge funds relatively free rein, regulatory overseers in Washington and elsewhere have essentially facilitated the spectacular growth of an industry with a voracious appetite for taking on risk. With limited liability and an asymmetric compensation structure that encourages many such operators to go for broke, regulatory arbitrage and intense competitive pressures means it won't just be sophisticated investors who feel the pain.
Historically, policymakers have viewed over-the-counter derivatives as the province of sophisticated financial operators who are capable of looking after their own interests. Yet by seemingly encouraging those who are actively involved with these often highly-leveraged securities to focus on profitability without any real oversight or incentives to take stock of the bigger picture, it is likely that the eventual violent unraveling will be in no one's interests.”
In the next chart we see additional evidence of the rise of the Financial Economy, wherein the Employment Cost Index show that one of the few areas where wage pressures abound is the ECI for the Financial Sector coming in nearly double the equivalent figure for private industry as a whole.
Source: Cleveland Fed
Elsewhere, the recent G-7 meeting at Davos, Switzerland revealed that other leading figures are getting seriously concerned. Never one to mince words, the Financial Times’ Gilliam Tett quoted ECB President Jean-Claude Trichet as stating that “current conditions in global financial markets look potentially 'unstable.'" According to Tett, Trichet went on to suggest that investors "prepare themselves for a significant 'repricing' of assets” with Trichet noting that “the recent explosion of structured financial products and derivatives had made it more difficult for regulators and investors to judge the current risks in the financial system.” Noted Trichet, "We are currently seeing elements in global financial markets which are not necessarily stable,” with Trichet pointing to the “low level of rates, spreads and risk premiums” as factors that could trigger a “repricing.” Trichet concluded his remarks to Tett stating that “There is now such creativity of new and very sophisticated financial instruments that we don’t know fully where the risks are located. We are trying to understand what is going on, but it is a big, big challenge.”
Ok, now I don’t know about you, but if he is the President of one of the worlds largest Central Banks and he doesn’t get it, ... Ah… where does that leave the rest of us? All of which brings us back to the DJIA and S&P, and the constant chorus of euphoria resounding through the hallowed halls of Cable TV where ‘in depth’ coverage often means nothing of the sort.
As can be seen in the chart above, the rally of the last few months for the S&P 500 appears to be in its final phases, with a clear-cut ‘five-wave’ pattern evident from the July 18, 2006 lows. With a bit of closer inspection, we see that the recent rally has sub-divided several levels down during the third wave advance. Using a very conservative and generous interpretation, the evidence points to some type of “fifth” wave rising wedge completing in this time frame. Note also that internal momentum within the advance appears to be diverging, signaling the prospect for a potentially more important trend reversal. As stated over the last several weeks, the 1,400 area for the S&P remains an initial support boundary and should be expected to hold during any first assault. Yet, the rally appears to be maturing, and against the backdrop of these broader concerns, one cannot help but wonder what unknown problems await for both the market, and for the safety of investors' capital when the vast uncorrected financial machinery of the past few years goes into reverse on the other side of a major top.
© 2007 Frank Barbera