Burst Bubble: Energy or Speculator?

Doug Noland, The Credit Bubble Bulletin, www.prudentbear.com  08/08/08

     Recent extreme global market volatility is part and parcel...[of]...Heightened Monetary Disorder...The Massive Global Pool of Speculative Finance has Run Amuck. The bulls will celebrate the rally, yet markets this unstable  are prone to “melt-ups” that lead to breakdowns.
 
Here’s how I see it. Many are rejoicing the bursting of the energy/commodities Bubble. Rapidly declining oil and resource prices are now expected to alleviate inflationary pressures, while bolstering household purchasing power. There’ll be no pressure on the Fed to raise rates, while their global central bank compatriots can soon begin cutting. The consensus view is that this is bullish for the U.S. economy and stock market and, if nothing else, market action did take attention away from troubling financial and economic news.
 
I am not one to easily dismiss notions of bursting Bubbles, and perhaps there is something to the energy bust thesis. I’m just skeptical of the idea that a slumping global economy is behind recent stunning price declines. Examining the global market backdrop, I sense different dynamics at play – important dynamics. And I tend to believe rapidly retreating commodities markets should be viewed in the context of a Bursting Leveraged Speculating Community Bubble.
 
The leveraged speculators have struggled since this year’s initial trading sessions. “Quant” and “market neutral” strategies in particular have foundered, although wild market volatility, illiquidity, and weak global securities markets have been an impediment for virtually all strategies. The hedge fund industry has been trying to adapt to tighter Credit conditions from the Wall Street firms and generally less liquid markets. Overall, leveraged strategies have been problematic, whether the underlying positions were in residential mortgages, commercial mortgages or corporate loans. The easy days of leveraged “spread trades” (“borrow cheap and lend dear”) quickly became quite difficult. And the easy returns in emerging markets turned abruptly into painful losses. Overall, global equities have performed quite poorly and global bonds somewhat poorly. Not many things have performed well and, worse yet, various trades that were supposed to offer diversification all became too tightly correlated.
 
Crude ended the first half at $140. Major commodities indices concluded June at record highs – sporting spectacular y-t-d gains. There’s no doubt that the speculator community had all crowded into the energy/commodities trade, one of a rapidly narrowing menu of speculations offering juicy (and desperately needed) returns. At the same time, the long energy/short financials “pairs trade” was also put on in great excess. The speculator community as well likely crowded further into dollar short positions, for years now an almost surefire winner. The more the crowded industry struggled for performance, the more they were forced to crowd into the same crowded trades. I would argue that the Bubble in the leveraged speculating community played a significant role in fueling energy/commodities prices inflation beyond what was justified by exceptionally bullish fundamentals. I wouldn’t, however, write off energy and commodities as burst Bubbles.
 
A lot of things had to go right for the vulnerable leveraged speculator community not to be pushed over the edge. Of course, markets tend to not accommodate the impaired – and the current market is particularly ruthless in this regard. The energy trade has unraveled badly. Commodities markets have been in near freefall. The dollar has mustered its most ferocious rally in quite some time. At the same time, agency debt and MBS spreads have widened, while global bond prices have offered little performance help. Corporate debt prices have performed poorly, while “private-label” MBS and various mortgage-related derivatives have traded dismally. Meanwhile, the financial stocks and other heavily shorted equities have rallied significantly. In short, a whole host of popular trades have gone wrong at the same time – a huge problem for the fragile industry.
 
We’re now in the midst of another one of these precarious periods. I believe global markets – equities, debt, currencies, and commodities – are all in some stage of dislocation (perhaps not emerging debt, at least yet). Trading conditions across the spectrum of markets are as chaotic as I’ve ever witnessed, a dislocation chiefly related to the now forced unwinds of speculative positions. Recent extreme global market volatility is part and parcel to the Heightened Monetary Disorder I have been addressing for months now. The Massive Global Pool of Speculative Finance has Run Amuck. The bulls will celebrate the rally, yet markets this unstable are prone to “melt-ups” that lead to breakdowns.
 
Earnings reports this week from Freddie Mac, Fannie Mae and AIG – three of our largest financial institutions – were horrendous. Financial sector hemorrhaging has actually accelerated, and definitely do not underestimate the impact of tightened Credit in the pipeline from Fannie, Freddie and others. With limited “capital” quickly evaporating, Freddie stated that its aggressive retained portfolio growth has come a conclusion. Fannie intimated about the same. Fannie will curtail purchases of alt-A loans, and it is clear that both companies have lost the capacity to provide the speculators a “backstop bid” in the MBS marketplace. This major additional tightening of mortgage Credit Availability and Marketplace Liquidity will further depress housing markets and bolster the headwinds buffeting our vulnerable economy.
 
Yet it is not the nature of dislocated markets to let fundamentals get in the way of price movement. Markets, after all, live on fear and greed. Sinking energy prices and a short squeeze ignited U.S. stocks this week. And surging stock prices always entice the optimistic viewpoint, with many viewing runs in stocks and the dollar as confirmation that the worst of the financial and economic crisis is behind us. The bursting of the so-called Energy/Commodities Bubble is also viewed in positive light.
 
Yet if the key dynamic is instead a Bursting Leveraged Speculating Community Bubble, entirely different dynamics are now in play. Enormous short positions have built up, the vast majority as part of “market neutral,” “quant” and myriad risk hedging strategies. If today’s dislocation develops into a significant unwind of these positions, the market immediately then becomes vulnerable to a disorderly “melt-up” followed almost inevitably by a sharp reversal and disorderly decline. The unwind of bearish speculations and hedges would be a most problematic market development, unleashing a final bout of speculative excess and disorder that would set the stage for a major market crisis.
 
It is not difficult to envision the backdrop for problematic market liquidation and deepening financial crisis. The hedge fund community is now susceptible to huge year-end redemptions, generally poor performance, shrinking assets & tighter Credit - all taking place in a climate of inhospitable market conditions which dictate ongoing Credit system de-leveraging. The pool of players willing and able to acquire U.S. risk assets is being depleted by the week. To be sure, the unfolding change of fortunes for the leveraged speculating community is one more key facet of tighter system Credit and faltering Marketplace Liquidity – extremely problematic Financial Conditions for the finance-driven U.S. Bubble Economy. And this makes the current market dislocations in the face of rapidly deteriorating fundamentals such a dangerous development.