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4 CREDIT BUBBLE
BULLETIN 'Risk on' risk
rises Commentary and weekly
watch by Doug Noland
My thesis contends
that we are in that late-stage of a multi-decade
global credit bubble. From a macro credit theory
perspective, this period of serial bubbles has
some well-defined general characteristics. First
of all, monetary policy is the prevailing force
behind the boom and bust cycles. Each bubble will
be larger than its predecessor, and each
successive post-bubble policy response will be
more aggressive and encompassing. The government's
role expands - before it becomes even bigger.
Curiously - one might say "ironically" -
as each grander new bubble becomes more systemic
the excesses generally turn less
conspicuous. The
technology/Internet bubble was spectacular,
although bubble-related (financial and economic)
impacts were generally contained to specific
industries/sectors (technology), financial assets
(tech stocks and telecom debt) and geographical
regions (California). The consequences from the
mortgage finance bubble were less conspicuous than
Nasdaq 5,000, while the impacts on spending and
investment patterns had much broader impacts on
the underlying structure of the US economy.
Today, in the midst of the greatest
financial bubble in history, most contend there's
no bubble at all. Bubble excesses have made it to
the heart/foundation of the US and global credit
system, while most analysts fail to see
problematic asset-price overvaluation (stocks,
bonds, real estate, etc). "Money" and "money"-like
instruments have at this late-stage of the cycle
become the core source of monetary inflation for
this crowning bubble.
This is critical, as
inflationary impacts have evolved to become deeply
systemic - and sufficiently all-encompassing to
ensure impacts are not readily evident and of a
different ilk from previous bubble manifestations.
Treasury debt has surreptitiously further
inflated incomes throughout the economy, spreading
inflationary purchasing power in a more balanced -
and seductively much less disruptive/alarming -
fashion than the previous tech and mortgage
finance bubbles. This has worked to sustain a
problematic economic structure and only exacerbate
US and global imbalances.
Importantly,
Treasury and Fed monetary fuel has inflated
financial asset prices across equities, bonds and
fixed-income more generally. Furthermore, monetary
inflation has inflated real assets, especially
anything providing an income stream (ie farm land,
rental homes, commercial real estate, etc) more
enticing than depressed cash and bond returns.
Moreover, the atypically systemic inflation in
securities prices has worked to broadly loosen
financial conditions and boost perceived wealth
throughout the economy, again limiting the degree
of conspicuous inflation and associated excess in
particular sectors.
It is also important
to appreciate that the nature of bubble dynamics
dictates that the reflation of system credit,
spending and risk-taking will require ever greater
policy measures to combat fallout from the
bursting of each larger/more systemic bubble. One
can think in terms of lower interest rates, larger
Fed purchases and more obtrusive market
interventions/manipulations. The Fed took rates
down to 1.75% in the 2000/'01 post-bubble rate
collapse, while the Fed's balance sheet ballooned
about $100 billion (to $660 billion).
In
the post-mortgage finance bubble reflation, the
Fed slashed rates to zero and the Fed's balance
sheet inflated about two trillion. The government
intervened throughout various asset markets (ie
essentially nationalizing mortgage credit), and
the Fed radically altered its (market
speculation-friendly) communications strategy.
As each boom and bust cycle is met with
easier financing conditions and greater official
sector market intervention, the resulting market
incentive structure entices heightened speculation
while bolstering speculative returns.
Accordingly, the scope of speculation
throughout the markets inflates right along with
the overall size of both the bubble and the
government's role in inflating the markets and
economic activity. Importantly, the policy and
market backdrops heavily distort the system's
pricing and incentive mechanisms, skewing returns
in favor of financial speculation and at the
expense of productive investment throughout the
real economy (ie the Fed chairman "Ben Bernanke
put" viewed as improving risk-taking prospects in
financial assets, although associated policy,
market and economic uncertainties provide a
powerful disincentive for major private-sector
capital investment projects).
Inevitably,
overbearing policy will ensure a problematic
divergence/decoupling between inflated securities
market prices and vulnerable bubble economy
underpinnings. This, importantly, creates
heightened uncertainty and market instability.
Resulting extreme monetary accommodation then
ensures that this divergence bubble dynamic
gathers further momentum. Right here one can
identify the root forces behind the "risk on, risk
off" ("roro") dynamic that has increasingly taken
command of global markets over the past few years.
I would contend that "roro" is in some
ways a microcosm of the overall bubble
environment. "Roro" also naturally gains momentum
with each successive round of mini-market
boom/bust and attendant aggressive policy
responses.
In 2011 and 2012, "roro" market
instabilities grew more powerful following each
intervention. Global markets rallied strongly
after 2011 policy measures (the European Central
Bank's Long-term refinancing operations, the Fed's
"twist," etc). Yet global markets were on the
verge of a much more serious crisis in the summer
of 2012. Acute financial and economic fragilities
ensured even more dramatic policy responses
(Outright Monetary Transactions from the ECB, more
"twist" and open-ended quantitative easing from
the Fed, and various stimulus from the Bank of
Japan, Swiss National Bank, People's Bank of
China, "developing" central banks, etc) that
provoked much greater price inflation throughout
global equities and fixed-income markets.
I tend to believe it's helpful to think of
2012 as a defining "capitulation year" in terms of
global policymaking. Global bubble fragilities and
an increasingly destabilizing "roro" speculative
market backdrop compelled policymakers to go all
in with their commitment to unlimited market
backstops and open-ended quantitative easing
programs. The "do whatever it takes" Mario Draghi
Plan at the ECB and the Fed's open-ended $85
billion monthly QE program are the poster children
for overwhelming policy responses that took almost
complete command over unsettled global markets.
Here's where I see the problem: the
increasingly overpowering and unstable "roro"
environment incited the "do whatever it takes"
capitulation policy response. Global central
bankers and policymakers saw the European crisis
spiraling out of control, with potentially
catastrophic consequences for the global financial
"system" and economy. They responded with the
overwhelming power they believed necessary to
quash "risk off" - only to motivate a runaway
"risk on".
This month's release of the
minutes from the December 11/12 rate-setting
Federal Open Market Committee meeting caused a
notable, though brief, market response. Particular
comments raised eyebrows: several members "thought
that it would probably be appropriate to slow or
to stop purchases well before the end of 2013...
Participants were approximately evenly divided
between those who judged that it would likely be
appropriate for the Fed to complete its asset
purchases sometime around the middle of 2013 and
those who judged that it would likely be
appropriate for the asset purchases to continue
beyond that date... While almost all members
thought that the asset-purchase program begun in
September had been effective and supportive of
growth, they also generally saw that the benefits
of ongoing purchases were uncertain and that the
potential costs could rise as the size of the
balance sheet increased."
What happened?
The tone from the minutes differed meaningfully
from the previous tones from both the Fed's
release on December 12 and the chairman's press
conference. Please indulge me, as I conjecture as
to what might be at work at the Fed.
First, I tend to believe that the Fed's
decision to move forward with open-ended QE was
primarily dictated by international financial and
economic fragilities unfolding over the summer.
Supporting the viewpoint of the critical role of
coordinated global central bankers responses were
two Wall Street Journal articles from Fed meeting
day, December 12, 2012: "Inside the Risky Bets of
Central Banks" (John Hilsenrath and Brian
Blackstone) and "MIT Forged Activist Views of
Central Bank Role and Cinched Central Bankers'
Ties" (Jon Hilsenrath). These articles implied
that the core of Fed policy has been dictated by
secretive meetings attended by a handful of global
central bankers.
Mario Draghi's stunning
"do whatever it takes" pronouncement was soon
followed by Bernanke's extraordinary commitment to
open-ended QE. Acute summer fragilities convinced
central bank chiefs of the need for an
overwhelming coordinated response. Along the way,
the Bernanke Fed was compelled to tell a little
fib: it explained its aggressive QE as a response
to weak US growth and unacceptably high
unemployment.
And despite some unusually
assertive pre-meeting public dissent (Lacker and
Fisher), the committee decided in December to
follow through with the chairman's late-summer
commitment with a planned $85 billion monthly bond
purchase program. The committee also proceeded
with a new economic indicator-based communications
strategy, tying (politically palatable) policy
accommodation to the US unemployment rate.
Confident that high unemployment will
persist for some time, analysts were quick to
extrapolate $85 billion monthly Fed purchases out
as far as 2015. Estimates for the future size of
the Federal Reserve's balance sheet inflated to as
high as five to six Trillion. The problem was that
the entire idea of an aggressive new QE program
emanated from a potentially catastrophic "risk
off" market environment replete with destabilizing
de-risking, de-leveraging and general global
turmoil. By the December FOMC meeting, however,
the markets were increasingly succumbing to
destabilizing "risk on." And by last week's FOMC
minutes release, the degree of speculative excess
apparent in global risk markets must have been
alarming to many members of the committee.
The way I see it, the Fed is now in a bit
of a pickle. With Bernanke's "it's all about jobs,
jobs and jobs", the little fib justifying
aggressive QE evolved more into a white lie. Some
Fed officials have been opposed to any additional
QE. Some were likely convinced by Bernanke over
the summer/fall that the fragile global backdrop
made aggressive monetary stimulus necessary. But
today, with global markets on fire, only the
hard-core doves would likely believe massive
ongoing QE is warranted. Many would today likely
see the risk of fueling asset bubbles as
overshadowing suspect QE benefits.
To this
day, the ECB is still pilloried for bumping up
rates in July 2008. There remains a rivalry
between Federal Reserve and ECB policymaking
doctrines. The Fed began slashing rates
aggressively in 2007. The ECB stood firm. With
crude at $140 and global markets still "dancing",
the disciplined ECB was "leaning against the
wind".
There are those (mainly on this
side of the Atlantic) that believe the ECB's July
rate increase provided an important catalyst for
the 2008 crisis. There are others (including
myself) convinced that the Fed's aggressive 2007
policy response stoked a problematic round of
global "risk on" that ensured that highly
speculative markets became perfectly synchronized
for a major crisis.
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