Credit Bubbles & Peso Problems
The following are extracts from recent commentary that appeared at The Speculative Investor web site.
The Bubble Trend
Below is an updated version of a chart comparison we've shown a couple of times in the past. It illustrates that the 12-month rate-of-change for the S&P500 Index has trended in the same direction as the yield on the T-Bond since mid-1997.
Long-term interest rates and equity market returns have been moving in the same direction for so long now that it seems normal for them to do so. It seems normal that every time bond prices trend lower for a few months, the stock market trends higher, and vice versa. It is, however, abnormal behaviour. Periods when rising interest rates occur in parallel with rising stock prices, or when falling interest rates occur in parallel with falling stock prices, have certainly happened in the past (prior to mid-1997), but such periods have seldom extended for longer than about 6 months. Under normal circumstances, rising bond prices (falling long-term interest rates) are a net-positive for the stock market and falling bond prices (rising interest rates) are a negative influence on stock prices. The reason this is so is that the present value of a company's future cashflow becomes less as interest rates rise.
When the bond market and the stock market move in opposite directions for a prolonged period it is a sign that either a) the economy is experiencing deflation, or b) the economy is experiencing a credit bubble. With the total supply of money having grown at a mind-boggling pace over the past 4 years the US has clearly not experienced anything remotely resembling deflation, nor is it likely to any time soon. With the inverse relationship between stocks and bonds now about to enter its 5th year it is clear that the US economy is under the influence of one of the all-time great credit bubbles.
We can use the current inverse relationship between bonds and stocks in three ways. Firstly, as long as we have good reason to believe that the credit bubble is still in existence then our bond market view should, beyond the very short-term, be the opposite of our stock market view. For example, if we expect the major stock market indices to move much higher over the coming 3 months (this is what we expect), then we should also expect bond prices to move lower over this period. Secondly, we can use a move in one market to confirm a move in the other market. For example, if a multi-week decline in stocks was not accompanied by a multi-week rally in bonds then we would have cause to be skeptical about the sustainability of the stock market decline. Thirdly, we will know that the bubble has ended when we see stock prices and bond prices moving sharply lower in unison.
Returning to the above chart we have indicated, via a vertical red line, that the beginning of April this year was another major turning point in the stock and bond markets. We are using some artistic license here since the trends are not yet well-defined, but the fact that both markets reversed direction at that time lends some support to the idea that early-April did, in fact, give us an important turning point in the markets.
As an aside, something that has occurred during the final stages of previous major credit bubbles is weakness in the currency of the country experiencing the bubble. As such, we expect to see a substantial and prolonged decline in the Dollar's foreign exchange value before the present US credit bubble comes to an end.
Another "Peso Problem"
Options trader and author Nassim Taleb coined the term "peso problem" to describe a situation whereby a security or trading strategy that has exhibited great stability and produced excellent returns over a long period of time suddenly, and unexpectedly, crashes. The term derives its name from the Mexican peso which, over the past 20 years, has experienced lengthy periods of stability interrupted by short periods of extreme turbulence. The attractive yields that can be earned on peso-denominated debt entice a huge amount of investment during the periods of stability. Everything seems wonderful until one day the peso suddenly plunges and interest rates go through the roof, quickly wiping out all the gains that were made over the previous period of stability and causing many of the yield-chasing speculators to 'blow up'.
All of our readers are undoubtedly familiar with the on-going Argentinean financial crisis. The Argentine peso is pegged to the US$, so the bulk of the stress is being felt in the debt market where Argentinean bond yields have skyrocketed. The crisis has over-flowed into neighbouring Brazil - the Brazilian real has plummeted against the Dollar and interest rates have risen dramatically. Strangely enough, however, the Mexican peso has, to date, been relatively unscathed by the crisis. In fact, although the Mexican peso has recently experienced some volatility it is the world's best performing currency so far this year.
To ascertain whether the present crisis will be 'contained' or whether it will lead to a global panic as happened in 1998, we will be watching both the Mexican peso and the PSE Bank Stock Index. If this crisis is going to broaden then we should soon start to see substantial weakness in the Mexican peso (as speculators try to exit while they still can) and in the stocks of the major banks (the major banks have immediate and direct exposure to any such crisis).
The US Baht
The "tiger" economies of SE Asia expanded their money supplies at high rates and ran large current account deficits during the mid-1990s. However, 'hot money' pouring into the region allowed the maintenance of stable exchange rates in the face of the current account deficits. With their currencies remaining firm on the foreign exchange market, the "tigers" were able to take advantage of low-priced imports and thus keep domestic prices in check despite being in the throes of huge credit expansions. Does all this sound similar to the situation that the world's largest economy finds itself in today?
In some ways, the current US situation closely parallels that of the tiger economies during the mid-1990s. A surging money supply growth rate has contributed to a large current account deficit whilst speculative money in-flows have kept the Dollar strong. As long as foreign-based speculators are willing to make big-enough bets on US$-denominated securities, the Dollar can remain strong. However, as soon as those hot money in-flows wane, the US Dollar becomes the US Baht.
We don't expect the US$ to follow in the exact footsteps of the Thai Baht, the Indonesian Rupiah or the Korean Won, but just think it is worth noting that the same forces at work in the US today were present prior to the collapse of the tiger currencies in 1997. The inevitable drop in the US$ will probably not be as spectacular as the crashes experienced by some Asian currencies a few years ago, but it will happen suddenly and it will take the vast majority by surprise.
25 July 2001
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