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     Dec 4, 2012

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Cliff drama approaches
Commentary and weekly watch by Doug Noland

It's imperative to constantly test one's thesis - in my case, an unconventional view of the world of finance, the markets and the global economy. Does one's analytical framework help explain system behavior? Of course, various perspectives come replete with biases, blurry vision and potentially perilous blind spots. Often it is too easy to simply see what one wants to see. At the same time, a sound framework and proper perspective create the opportunity for more objective analysis. I'll add that history has shown that this all becomes keenly relevant during manias.

The US stock market has more than doubled from 2009 lows. Financial conditions seemingly couldn't be looser. November saw a record US$165 billion of US corporate debt issuance. This year will see near record corporate debt sales. Junk bond issuance will


be a new all-time high. System credit growth will be the strongest since 2008. Recently, consumer confidence has jumped to a four-year high. The nation's housing markets are showing signs of life. Gross domestic product (GDP) would be generally OK, except for the matter of the unprecedented fiscal and monetary excess necessary to generate such limited economic expansion.

The conventional bullish view holds that 2008 was the proverbial "100-year flood". A new secular bullish cycle has commenced that will, again, prove the naysayers wrong. The bullish view holds that Federal Reserve chairman Ben Bernanke's unrelenting monetary stimulus in high regard. And while most would claim they prefer an end to fiscal profligacy, most also hold to the notion that actual fiscal tightening should be done gradually so as to not impinge the fledgling recovery. There will be a more opportune time to address fiscal issues later. Ongoing fiscal and monetary stimuli are viewed as essential for bolstering a post-bubble economy buffeted by various headwinds from home and abroad.

The bearish thesis perspective sees things altogether differently. Fundamentally, I disagree with the post-bubble backdrop premise - and not for the first time. When Bernanke emerged onto the scene back in 2002 to fight so-called post-bubble deflation, it was clear to me that aggressive monetary stimulus would inflate the incipient mortgage finance bubble. It became clear in early-2009 that even more incredible fiscal and monetary stimulus would inflate the fledgling "government finance bubble". With today's confluence of years of trillion-dollar deficits and historically inflated bond prices, the benefit of the doubt belongs with the bubble thesis.

It was another eventful week in the realm of the global government finance bubble. Here at home, we're now less than 31 short days (counting holidays!) from dropping off the "fiscal cliff". This predicament has been on the horizon for many months, though it's obvious that Washington has not been dealing seriously with this issue. While pundits have been quick to explain that both sides are merely posturing, it appears that last-minute negotiations are beginning with both sides somehow miles apart.

The Democrats are emboldened, while the Republicans are no less determined. One side is focused on increasing taxes on the wealthy, the other on spending cuts. In a world of deep philosophical and irreconcilable differences, it has all the makings of a tense year-end drama.

From my distant vantage point, I ("master of the obvious") see a low likelihood of meaningful spending restraint. The serious entitlement spending issue will, not unexpectedly, be left for another day - and then another. Even Republican proposals have most so-called "savings" occurring a decade out.

Not surprisingly, at least from the "government finance bubble" perspective, the previous huge inflationary surge in federal outlays has essentially become today's new baseline. Off the table. Non-negotiable. Instead, "cuts" are basically commitments to somehow - and in some undetermined ways - reduce future (generally 10-20 years) expenditure growth.

Not coincidently, dysfunctional fiscal policy was conjoined last week with dysfunctional monetary policy. Clearly, serious fiscal restraint will not be forthcoming until the markets forcibly squeeze it out of Washington. The bond and stock markets should today be pressuring the administration and congress - yet that's not in the cards with the Fed talking $85 billion of monthly quantitative easing starting in January.

Last week, Bill Dudley, president of the Federal Reserve Bank of New York, joined the ranks of Fed policymakers signaling support for greater monetary stimulus. At the same time, Dudley confidently stated that "we will absolutely take away the punchbowl when the time is right". Well, I can state with confidence that the Fed absolutely won't. Factually, the Federal Reserve repeatedly hasn't (ie 1988, 1993, 1999, 2005/06).

Tuesday from Paul Volcker (CNBC interview): "It's [when to remove stimulus] a very hard judgment to make. Sometimes you'll be wrong. But you've got to - I think that is the chronic problem of any central bank because the implication is you have to begin tightening before the excess demand, before the bubbles, before the inflationary process is under way because it's more difficult if you're too late. But if you do it, by definition, people are going to complain. 'Why are you removing the proverbial punch bowl before the party's really gotten drunken?' But that's what a responsible host does. He waters the punch bowl in time.'"

I respect former Fed chairman Paul Volcker. He is among a select very few with real inflation-fighting credentials. Yet I also don't believe he recognizes the nature of current inflationary manifestations. Volcker warns of the need for reducing stimulus before the "inflationary process" commences, without appreciating the monetary bubble already unleashed by profligate Federal spending coupled with profligate Federal Reserve monetary policy.

Dudley, Volcker and others can surmise a timely removal of the punchbowl, yet I recall Henry Kaufman arguing convincingly back in 1999 that there would be severe consequences associated with the Fed having badly missed its timing. Little did we know at the time...

My thesis remains that we are at the late-stage of a historic multi-decade global credit bubble. At its core, this monetary fiasco is about a failed experiment with unconstrained global electronic-based finance. Using history as a guide, credit bubbles and associated manias tend to turn highly unstable near a cycle's end. From an inflationary cycle perspective, one can expect increasingly desperate policy measures in a fateful effort to sustain the unwieldy credit boom. One would also hope to see more vocal dissent from those opposing a further ratcheting up of monetary inflation.

A week ago, I profiled a refreshingly hawkish view espoused by Jeffrey Lacker, president of the Richmond Fed. I was encouraged further by similar thinking last week from another prominent Federal Reserve official.

On Tuesday from Bloomberg (Stefan Riecher and Aki Ito):
Federal Reserve Bank of Dallas President Richard Fisher said he advocates putting limits on US quantitative easing. The Fed could announce "a limit as to how much we are going to acquire of treasuries and mortgage-backed securities, say up to a limit of X, up to a point where our balance sheet reaches that," Fisher said... "It is my personal preference to do it sooner than later, perhaps at the next meeting." Fed officials plan to meet Dec 11-12 to assess whether record accommodation is fueling economic growth and reducing 7.9% unemployment, and to debate whether to extend the Operation Twist stimulus plan, which expires next month. Fisher... has been among the most vocal Fed officials against more easing. Fisher said there are lessons to be drawn from Germany's experience of hyperinflation during the 1920s. While today's situation is different and he wasn't suggesting accommodative monetary policies would lead to inflation, Fisher said they can't be left in place forever. "There is no such thing as QE infinity," he said. "QE infinity gets you into trouble.'"
One can hope that perhaps the more responsible Federal Reserve officials have seen just about enough. Despite loose financial conditions, booming debt markets, strong/speculative risk markets, massive federal deficits and robust system-wide credit growth - the dovish contingent is nonetheless hell-bent on significantly boosting its "money printing" operations.

After Lacker's speech and Fisher's comments, I was hopeful that the December 11-12 meeting of the Federal Open Market Committee might provide the venue for the hawks to finally take a stand. This hope was crushed (like a bug) at 3:24 pm on Wednesday with the posting of Jon Hilsenrath's "Fed Stimulus Likely in 2013" article on WSJ.com: "Three months after launching an aggressive push to restart the lumbering US economy, Federal Reserve officials are nearing a decision to continue those efforts into 2013 as the US faces threats from the fiscal cliff at home and fragile economies elsewhere in the world."

Hilsenrath's article generously quotes ultra-doves John Williams (San Francisco Fed president) and Charles Evans (Chicago Fed president). It mentions the views of Bernanke, Janet Yellen (vice chair of the Fed board of governors) and Lockhart (Atlanta Fed president). Curiously absent, however, was any reference to Lacker or Fisher. Not a peep of any internal debate regarding the size of the Fed's balance sheet.

The article instead implied the decision to loosen further had all but been made: additional QE begins in January, with total bond/MBS (mortgage-backed securities) purchases in the neighborhood of $85 billion a month. After trading down 100 points in the morning, the Dow Jones Industrial Average closed Wednesday's session up 107. The dollar, having seemed to catch a Lacker/Fisher bid, reversed sharply lower. "Risk on, Risk off" pivoted back toward risk on, confident as ever in the policy-based liquidity backstop. "Fiscal cliff" worries? Well, once again, worry ensures more QE. It's become a bad habit.

From my perspective, there's ample confirmation that we're at the wild "blow-off" phase of speculative market excess. Whether we're late in the party - with markets rather numb to the punchbowl - or whether there's still more of the manic endgame to endure, only time will tell. But it has reached the point where monetary stimulus has much more impact on the markets than it does on real economies.

From a global perspective, the dismal economic news out of Europe is unrelenting. From China comes more stories and anecdotes of corruption and financial rot. It is also worth noting that both India and Brazil posted disappointing growth numbers last week, even more notable since both economies have stagnated in the face of ongoing rampant credit expansion. 

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