by Doug Noland
June 27, 2014
Earlier in the week BlackRock’s Larry Fink commented on CNBC: “A Bubble is predicated on leverage.” Fink was implying that he didn’t see the type of leverage that fueled the previous Bubble.
As part of my Bubble analysis framework, I have posited that the more conspicuous a Bubble the less likely it is to be systemic. The “tech” Bubble was conspicuous, though gross excesses impacted only a relatively narrow segment of asset prices and a subsection of the real economy.
I received a lot of pushback to my mortgage finance Bubble thesis during that Bubble period. The conventional view held that excesses were not a major issue, especially when compared to the Internet stocks and all the nonsense illuminated with the technology Bubble collapse. The Fed’s unwillingness to move beyond baby-step rate increases (to aggressively tighten Credit) played prominently in Bubble Dynamics. Today, conventional thinking sees a system that has been working successfully through a multi-year deleveraging process. Leverage and speculative excess are believed to be nothing on the order of those that gave rise to the (“100-year flood”) “Lehman crisis.”
As an analyst of Bubbles, I’ve definitely got my work cut out for me. I have seen overwhelming evidence in support of my “Granddaddy of all Bubbles” – global government finance Bubble – thesis. Yet the Bubble is so comprehensive – so systemic – that the greatest financial Bubble in human history somehow goes largely unappreciated – hence unchecked.
Understanding this era’s Credit Bubble (as opposed to the causes of the Great Depression) will prove the ultimate “Holy Grail of Economics.” The past 25 years have been unique in financial history. Indeed, the world is trapped in a perilous experiment with unfettered finance - with no limits on either the quantity or quality of Credit created. Closely associated with this trial in unchecked electronic finance (“money” and Credit) has been runaway experimentations in “activist” monetary management.
Just as crucial is the experiment in unconventional economic structure – including the deindustrialization of the U.S. economy, with the corresponding unprecedented expansion of industrial capacity throughout China and Asia. This has engendered a period of unmatched global economic and financial imbalances – best illustrated by the massive and unrelenting U.S. Current Account Deficits and the accumulation of U.S. IOU’s around the globe.
The amazing thing to me is that the world has been subjected to more than 25 years of brutal serial boom and bust cycles (going back to 1987 – although there’s a strong case to start at 1971) – yet there has been no effort to reform either a patently flawed global financial “system” or a reckless policymaking doctrine. Instead, global central bankers have turned only more “activist,” drifting further into the bizarre (that passes for “enlightened”). The world’s leading central banks have resorted to rank inflationism, massive “money” printing operations specifically to inflate global securities markets. And the resulting raging “bull” markets ensure bullishness and a positive spin on just about everything. The sophisticated market operators play the speculative Bubble for all its worth, while the unsuspecting plow their savings into stock and bond Bubbles.
Credit is inherently unstable. Marketable debt instruments exacerbate instability. A financial system where Credit expansion is dominated by marketable debt (in contrast to “staid” bank loans) is highly unstable - I would argue unwieldy, whimsical and prone to manipulation. And a monetary policy regime that specifically nurtures and backstops a system dominated by marketable securities and associated speculation is playing with fire. Importantly, the more deeply central bankers intervene and manipulate such a system and the longer it is allowed to inflate – the more impossible for these central planners to extricate themselves from the financial scheme.
I’m fond of a relatively straightforward analysis that does a decent job of illuminating the state of ongoing U.S. (marketable securities) Bubbles. From the Fed’s Z.1 “flow of funds” data, I tally Total Marketable Debt Securities (TMDS) that includes outstanding Treasury securities (not the larger Federal liabilities number), outstanding Agency (MBS & debt) Securities, corporate bonds and municipal debt securities.
My calculation of TMDS began the 1990’s at $6.28 TN, or an already elevated 114% of GDP. Led by explosive growth in GSE and corporate borrowings, TMDS ended the nineties at $13.59 TN, for almost 120% growth. Over this period, GSE securities increased $2.65 TN, or 209%, to 3.916 TN. Corporate bonds jumped 185% to $4.564 TN. It is worth noting that total Business borrowings expanded 9.2% in 1997, 11.5% in 1998 and 10.4% in 1999, excess that set the stage for the inevitable bursting of the “tech” Bubble.
The Fed’s aggressive post-tech Bubble reflation ensured already dangerous excess was inflated to incredible new extremes. On the back of a doubling of mortgage borrowings, TMDS expanded 102% in the period 2000 through 2007 to $27.50 TN. Over the mortgage finance Bubble period, Agency Securities jumped 89% to $7.40 TN. Corporate bonds surged 154% to $11.577 TN. Municipal bonds rose 135% to $3.425 TN.
This unprecedented Credit expansion fueled various inflationary manifestations, including surging asset prices, spending, corporate profits, investment, GDP and trade/Current Account Deficits. After beginning the nineties at $6.227 TN, the value of the U.S. equities market surged 409% to end the decade at $19.401 TN. As a percentage of GDP, the nineties saw TMDS jump from 114% to 147%. Spurred by crazy technology stock speculation, Total Securities – TMDS plus Equities – jumped from 183% to end 1999 at 356% of GDP. Although Total Securities to GDP retreated to 284% by 2002, mortgage finance Bubble excesses quickly reflated the Bubble. Total Securities ended 2007 at a then record 378% of GDP.
A “funny” thing happened during the post-mortgage Bubble’s so-called “deleveraging” period. Since the end of 2008, total TMDS has jumped $8.348 TN, or 29%, to a record $37.542 TN. As a percentage of GDP, TMDS ended Q1 2014 at a record 220%. Even more importantly from a Bubble analysis perspective, in 21 quarters Total Securities (debt & equities) inflated $27.2 TN, or 61%, to end March 2014 at a record $72.039 TN. To put this in context, Total Securities began 1990 at $10.0 TN, ended 1999 at $33.0 TN and closed 2007 at a then record $53.01 TN.
Amazingly, Total Securities as a percent of GDP ended Q1 at 421%. For comparison, Total Securities to GDP began the nineties at 183%, ended Bubbly 1999 at 356% before peaking at 378% in a more Bubbly 2007. No Bubble today? “Valuations in historical range”?
Let’s return to “A Bubble is predicated on leverage.” Yes, Total Household Liabilities declined $715bn from the 2008 high-water mark (much of this from defaults). Yet over this period federal liabilities increased almost $10.0 TN. Corporate borrowings were up more than $2.3 TN. On system-wide basis, our system is inarguably more leveraged today than ever.
Many contend there is significantly less speculative leverage these days compared to the heyday (“still dancing”) 2007 period. I’m not convinced. Perhaps there’s less leverage concentrated in high-yielding asset- and mortgage-backed securities. However, from today’s vantage point, there appears to be unprecedented “carry trade” leverage on a globalized basis. I’ve conjectured that the “yen carry trade” – using the proceeds from selling (or borrowing in) a devaluing yen to speculate in higher-yielding securities elsewhere – could be one of history’s biggest leveraged bets.
Various comments also suggest that there is enormous leverage employed in myriad Treasury/Agency yield curve trades. I suspect as well that the amount of embedded leverage in various securities and derivative trades in higher-yielding corporate debt is likely unprecedented.
When it comes to leverage, the Federal Reserve’s balance sheet is conspicuous. Fed Assets will end the year near $4.5TN, with Federal Reserve Credit having expanded about $3.6 TN, or 400%, in six years. Few, however, appreciate the ramifications from this historic monetary inflation from the guardian of the world’s reserve currency. I find it astonishing that conventional thinking dismisses the market impact from this historic inflation of central bank Credit.
Over the years, I have argued that “money” is integral to major Bubbles. A Bubble financed by junk debt won’t inflate too far before the holders of this debt begin to question the rationale for holding rapidly expanding debt of suspect quality. In contrast, a Bubble fueled by “money” – a perceived safe and liquid store of nominal value – can inflate for years. The insatiable demand enjoyed by issuers of “money” allows protracted excesses and maladjustment to impart deep structural impairment (financial and economic).
I’m convinced history will look back and view 2012 as a seminal year in global finance. Draghi’s “do whatever it takes,” the Fed’s open-ended QE, and the Bank of Japan’s Hail Mary quantitative easing will be seen as a fiasco in concerted global monetary management. The Fed’s QE3 will be viewed as an absolute debacle.
After all, QE3 incited an unwieldy “Terminal Phase” of speculative Bubble excesses throughout U.S. equities and corporate debt securities, along with global securities markets more generally. It unleashed major distortions throughout all markets, including sovereign debt.
A quick one-word refresher on “Terminal Phases:” Precarious. Their inherent danger arises from egregious late-cycle speculative excess and attendant maladjustment coupled with timid policymakers. Over recent years I have repeatedly invoked “Terminal Phase” in my analysis of a progressively riskier Chinese Bubble backdrop impervious to hesitant policy “tinkering.”
Here at home, we’re beginning to hear the apt phrase “The Fed is behind the curve.” Traditionally, falling “behind the curve” indicated that the central bank had been too slow to tighten policy in the face of mounting inflationary pressures. “Behind the curve” dictated that more aggressive tightening measures were required to rein in excesses.
These days, “behind the curve” is applicable to an inflationary Bubble that has taken deep root in stock and bond markets. With the Yellen Fed seen essentially promising to avoid even a little baby-step 25 bps rate bump for another year, highly speculative Bubble markets can blithely disregard poor economic performance, a rapidly deteriorating geopolitical backdrop and the approaching end to QE. Worse yet, market participants are emboldened that “behind the curve” and the resulting dangerous market Bubbles preclude the Fed from anything but the most timid policy responses. A dangerous market view holds that, after instigating inflating securities markets as a direct monetary policy tool to stimulate the economy, the Fed would not in any way tolerate a problematic market downturn.
June 26 – Bloomberg (Steve Matthews and Jeff Kearns): “Federal Reserve Bank of St. Louis President James Bullard predicted the central bank will raise interest rates starting in the first quarter of 2015, sooner than most of his colleagues think, as unemployment falls and inflation quickens. Asked about his forecast for the timing of the first interest-rate increase since 2006, he said: ‘I’ve left mine at the end of the first quarter of next year.’ ‘The Fed is closer to its goal than many people appreciate,’ Bullard said… ‘We’re really pretty close to normal…’ If his forecasts bear out, ‘you’re basically going to be right at target on both dimensions possibly later this year… That’s shocking, and I don’t think markets, and I’m not sure policy makers, have really digested that that’s where we are.’”
The same day Bullard was talking hawk-like, Federal Reserve Bank of Richmond President Jeffrey Lacker was also making comments that should have the markets on edge. Countering uber-dove Yellen, Lacker stated that the recent jump in inflation was not entirely “noise.” Interestingly, he suggested that the Fed follow closely the FOMC’s 2011 exit strategy. “It’s not obvious to me a larger balance sheet should change any of our exit principles.
I still think we should, as our exit principles say, be exiting from mortgage backed securities as soon as we can...” And following the lead of Kansas City Fed head Esther George, Lacker believes the Fed should allow its balance sheet to begin shrinking by ending the reinvestment of interest and maturity proceeds. Bullard also said the Fed should consider ending reinvestment.
Market ambivalence notwithstanding, I’m sticking with my analysis that the Fed can’t inflate its balance sheet from $900bn to $4.5 TN – and then end this massive monetary inflation without consequences. Things get even more interesting when talk returns to the Fed’s 2011 “exit strategy” road map. Regrettably, instead of exiting the Fed doubled-down – literally. And Dr. Bernanke may now say (while earning $250k) that the Fed’s balance sheet doesn’t have to shrink even “a dime.” Yellen and Dudley likely agree. But there’s now a more hawkish contingent that has other things in mind, and I don’t believe they will be willing to simply fall in line behind Yellen as officials did behind Greenspan and Bernanke.
Actually, I believe the so-called “hawks” (i.e. responsible central bankers) are gearing up to try to accomplish something that might these days appear radical: normalize monetary policy. Read “Systematic Monetary Policy and Communication” presented this week by Charles Plosser. Read Esther George’s “The Path to Normalization.” Re-read Richard Fisher. While you’re at it, read John Taylor’s op-ed from Friday’s WSJ: “The Fed Needs to Return to Monetary Rules.” I’m with Taylor (and Plosser!) on having and following rules. I’m also with Bullard: “I don’t think markets… have really digested… where we’re at.”