Bubbles & Schemes

by Doug Noland

July 25, 2014  

Cracks appearing in junk bonds

The “economic sphere” versus “financial sphereanalytical framework has in the past been a CBB focal point. Over recent years I have not given this type of analysis the attention it deserves. Conventional analysis holds that the real economy drives the performance of the markets

During bull markets, pundits fixate on every little indicator supposedly corroborating the optimistic view. These days, the bulls trumpet strong underlying profit growth as supporting ever higher stock prices.

Especially in this Age of Unfettered Finance, I’m convinced that the “financial spherecommands the “economic sphere.” Profits are generally a byproduct of strong underlying growth in financehence a lagging indicator. Corporate earnings will appear absolutely stellar at market peaks – as Credit flows freely and financial conditions remain ultra-loose. Profits will be lousy at market bottoms, when risk aversion and attendant tight financial conditions dominate.

Going back now more than twenty years, a primary analytical objective of mine has been to identify, study and monitor the underlying finance fueling booms in markets and economic activity. Fundamental analytical issues include: What is the nucleus of the underlying Credit expansion? Whose balance sheets/liabilities are growing? What is the nature of the prevailing financial flows? How stable are the underlying Credit and flow dynamics? What is the role of policymaking and government market intervention? Are there major market misperceptions and resulting mispricings?

Today’s consensus view holds that the economy and markets are soundrobust even. The economy is finally emerging from a difficult post-Bubble period, with the markets appropriately valued based on improving fundamentals. We are assured by central bankers and pundits alike that markets have not succumbed to yet another Bubble. Top officials at the Fed and ECB have both recently stated that underlying Credit growth and market leverage are inconsistent with a problematic Bubble backdrop.

I have repeatedly identified troubling parallels between the past twenty year cycle and the protracted boom that ended with the 1929 stock market crash. Having extensively studied the late-twenties period, I was repeatedly struck by how virtually everyone was caught unaware of acute underlying financial and economic fragilities. “How could they have not seen it coming?,” I often asked myself. It all makes clearer sense to me now.

Importantly, this has been a particularly prolonged Credit and speculative cycle (exceeding even the historic 1914-1929 boom). Similar to 1929, everyone has become numb to the scope of Credit excess, speculative leveraging and economic maladjustment. Back in the sixties, Alan Greenspan was said to have pointed responsibility for the financial collapse and resulting Great Depression on a misguided Federal Reserve that had repeatedly placed coins in the fuse box” to sustain the Twenties boom.

Clearly, a protracted period of repeated central bank market interventions will solidify the notion that adroit policymakers have everything under control. And given enough time – and sufficient inflation in Credit and financial asset markets price distortions will become deeply systemic if not commonly appreciated

Importantly, protracted booms create cumulative deleterious effects that, by the nature of things, go completely unappreciated in the precarious terminal phase” of Bubble excess.
I titled a presentation back in early-2000, “How Could Irving Fisher Have been so Wrong?Only days before the great 1929 crash, the leading American economist at the time famously stated: “Stock prices have reached what looks like a permanently high plateau. I do not feel there will be if ever a 50 or 60 point break from present levels…”

Fisher and about everyone else at the time were oblivious to underlying financial and economic fragilities. With this in mind, I will touch upon what I believe are sources of potential vulnerability. In particular, my focus is on potentially unstable Credit and financial flows – the “financial sphere”.

First of all, Credit financing asset speculation is inherently unstable. Broker call loans and various leveraged structures proved catastrophic in the 1929 crash and subsequent financial meltdown. During booms, speculative leveraging engenders their own self-reinforcing liquidity abundance. But as we saw firsthand during the 2008/09 fiasco, the cycle’s vicious downside, with the forced unwind of speculative leverage, pressures market liquidity and asset prices in a self-reinforcing market crash. Contemporary central banking has regressed to little more than a scheme intent upon bolstering securities and asset prices.

It is my view that the current amount of global speculative leverage across securities and asset markets is surely unprecedentedstocks, bonds, EM, real estate, collectables, etc. The global leveraged speculating community has grown significantly since the ’08 crisis, while there has been a proliferation of instruments, vehicles and funds that boost returns through the use of embedded leverage. Anecdotes suggest globalcarry tradespeculative leverage has inflated to unprecedented extremes, certainly bolstered by central bank currency/liquidity manipulation (the U.S., Japan and China at the top of the list). And I worry that booming markets for ETFs and derivatives (of all stripes) ensure the utilization of massive amounts of leverage (along with trend-reinforcingdynamic tradinghedging strategies).

At the same time, record margin debt and boomingrepomarkets suggest speculative leverage from traditional sources remains as prominent as ever. What are the ramifications for system stability from record quantities of stocks and bonds at record high prices underpinned by record amounts of speculative leverage?

Sheila Bair penned an interesting op-ed in Friday’s Wall Street Journal: “The Federal Reserve’s Risky Reverse Repurchase Scheme.” I appreciate the analysis and particularly the notion of a “scheme.” I actually believe that there is a critically important evolution that occurs during protracted Credit and speculative cycles. In simple terms, over time runaway financial and economic booms transforms from a Bubble dynamic to one more akin to a sophisticated financial scheme.

Importantly, mounting financial and economic fragility fosters progressive government intrusion throughout the markets and real economy. Resulting market instability and poor economic performance then provokes only more meddlesome governmentactivism.” As we’ve witnessed over the past six years, massive fiscal spending has bolstered the economy and inflated corporate profits. Meanwhile, central bank interest-rate manipulation, market intervention and massivemoneyprinting incited risk-taking and incentivized speculative leveraging. If the great American economist Hyman Minky were alive today, he would undoubtedly label this one of history’s most outrageous episodes of Ponzi Finance.

It’s certainly no coincidence that we’ve been witnessing a proliferation of financial jerry-rigging. The loosest financial conditions imaginable have spurred record stock buybacks that have bolstered equities prices, while goosing earnings-per-share (EPS). Other popular methods of financial engineering include “tax inversions,” master limited partnership and various other tax avoidance schemes that work to inflate equity market valuation. Government and central bank largesse has also incited a historic M&A boom that will leave a legacy of problem debt.

It’s surprising that there has not been more concern regarding conspicuous excess throughout the corporate debt market. Corporate borrowings are notoriously cyclical and potentially disruptive. One can look back to the late-eighties corporate debt boom and resulting early-nineties bust. Then there were late-nineties excesses that left a legacy of problematic telecom debt, along with a severe tightening of Credit conditions. Yet those excesses were left in a trail of dust by the 2006/07 corporate lending fiasco that played prominently in the subsequent financial crisis.

So let’s take a brief look under the hood of today’s corporate debt boom (beyond record issuance of bonds, risky and otherwise). From the Fed’s Z.1 flow of fundsreport we see that non-financial corporate borrowings increased a seasonally-adjusted and annualized (SAAR) $873bn during Q1, up sharply from Q4 and at a pace surpassing even 2007’s record $862 growth in corporate debt. It is worth noting that the two-year 2012-2013 corporate debt increase of $1.45 TN surpassed the $1.42 Trillion gain from 2006-2007. And while we’re at it, the 1998-1999 lending boom saw corporate debt increase $801bn and the 1987-1988 Bubble saw growth of $395bn. Some would argue that the 9% (or so) pace of corporate debt growth over the past nine quarters remains below 2007’s 13.6%, 1998’s 10.8% and 1987’s 10.4%. I would counter that today’s record low corporate borrowing costs work to somewhat temper overall growth in corporate Credit. Excesses – including issuance and mispricing - are greater than ever.

The cyclical boom and bust dynamic saw Credit expansion slow rapidly during the early nineties, with corporate debt actually contracting 2.3% in 1991 (and growing only 0.8% in ’02). Booming corporate debt growth was cut in half by 2001, and then expanded only 1.3% in 2002 and 2.0% in 2003. Corporate borrowings were also cut in half in 2008, before contracting 3.1% in 2009 (expanding only 1.7% in 2010). Importantly, corporate debt is prone to cyclicality and instability.

Returning to “financial sphereanalysis, I discern latent fragility. Sure, Q1 total non-financial sector Credit expanded SAAR $2.113 TN (up from 2013’s $1.812 TN), surpassing my $2.0 TN bogey for Credit sufficient to drive a maladjusted economic structure. But the federal (SAAR $874bn) and corporate (SAAR $873bn) sectors accounted for the vast majority of system Credit expansion. And I believe both Credit booms have been heavily impacted by central bank QE liquidity injections. After all, Fed holdings expanded SAAR $911bn during Q1, after surging $1.086 TN in 2013. Importantly, we’re now only a few months away from the end of QE.

July 25 – Financial Times (Vivianne Rodrigues and Michael Mackenzie): Junk bonds are on track for their worst monthly return in nearly a year, with investors fretting the era of easy US central bank money is at an end and calling time on a bull run for one of the market’s riskier asset classes. Years of quantitative easing by the Federal Reserve have driven investors into bonds, real estate and equities, sparking concerns of looming asset price bubbles. Junk-rated debt, in particular, has attracted record inflows and generated robust returns for investors prepared to bet on bonds sold by companies with the lowest credit ratings.”

July 25 – Wall Street Journal (Katy Burne and Chris Dieterich): Investors are selling junk bonds at the fastest pace in more than a year, as fresh interest-rate fears and geopolitical turmoil amplify valuation concerns following a long rally. Prices on bonds issued by lower-rated U.S. companies tumbled to a three-month low this weekInvestors yanked $2.38 billion from mutual funds and exchange-traded funds dedicated to junk bonds in the week ended Wednesday, the largest weekly withdrawal since June last year, said… Lipper. That came on the heels of $1.68 billion that poured out the week beforeCompanies have taken note, with some borrowers delaying scheduled debt sales and others canceling planned deals. New issuance is on track for its slowest month since February, according to… Dealogic.”

I suspect that the end of QE could very well send shudders throughout the corporate debt marketplace, and I would furthermore expect the initial tightening of financial conditions to manifest with the marginaljunkborrowers. Especially after hundreds of billions have flooded into high-yielding vehicles (certainly including the ETF complex), an abrupt reversal of flows would spell Credit tightening trouble. Further, any meaningful deterioration in corporate Credit Availability would have negative ramifications for an overextended stock market Bubble. As I have written previously, with QE winding down the securities markets are increasingly vulnerable to a destabilizing bout of “risk off.” It wouldn’t require a major de-risking/de-leveraging episode to dramatically alter the marketplace liquidity backdrop.

There is another element of “financial sphereanalysis that I believe could play a major role in unappreciated latent fragilities: Integral to the “global government finance Bubblethesis is that excesses today encompass the world and virtually all asset classes. While not readily apparent, I believe there are various international financial flows that today stoke asset inflation and Bubblesflows that could prove especially destabilizing in the event of globalized financial tumult. Myriad flows originating from the likes Japan, China, overheated EM Credit systems and elsewhere unobtrusively inject liquidity and drive price gains throughout our stocks, bonds, real estate and the real U.S. economy more generally.

July 16 Wall Street Journal (Min Zeng)China Plays a Big Role as U.S. Treasury Yields Fall – Record Chinese Purchases of Treasurys Help Explain U.S. Bond Rally.” Investors wrestling with the mysterious U.S. bond rally of 2014 got a clue about where to look: China. The Chinese government has increased its buying of U.S. Treasurys this year at the fastest pace since records began more than three decades ago… The purchases help explain Treasurys' unexpectedly strong rally this year… The world's most-populous nation boosted its official holdings of Treasury debt maturing in more than a year by $107.21 billion in the first five months of 2014… “

July 9 – Los Angeles Times (Tim Logan): “A record amount of foreign money is flowing into the U.S. housing market Overseas buyers and new immigrants accounted for $92 billion worth of home purchases in the U.S. in the 12 months ended in March That’s up 35% from the year before, and the most ever. Nearly one-fourth of those purchases came from Chinese buyers. And the place they're looking most is Southern California… The report highlights the growing effect of global capital on some local housing markets. The $92 billion amounts to 7% of all money spent on homes in the U.S. during those 12 months, and nearly half of it was concentrated in a handful of cities, including Los Angeles.”

Perhaps it’s coincidence that the ECB is commencing a major new liquidity operation just as the Fed’s QE winds down. Clearly, the “Draghi plan” to bolster fragile European peripheral debt markets should be viewed as a sophisticated financial scheme. Thus far, the Bank of Japan (BOJ) shows no indication that its “moneyprinting scheme is ending anytime soon. And despite all the talk that the Chinese were serious about financial and economic reform, they apparently took one alarming look at rapidly unfolding systemic fragilities and opted to let their historic Bubble run. The Chinese Bubble is a government-dictated financial scheme of epic proportions.

So it’s become an equally fascinating and alarming global dynamic: a multifaceted global scheme to support inflated securities markets and a grossly maladjusted global economic structure. Worse yet, it’s a global scheme held together by various governments that are increasingly engaged in heated geopolitical strife. In the end, “Ponzi Financefinancial schemes boil down to games of confidence.

So I’ll attempt the briefest responses to the above noted key questions: What is the nucleus of the underlying Credit expansion? Answer: Non-productive government debt, speculative leverage and borrowings to support financial engineering. Whose balance sheets/liabilities are growing? Answer: The Fed’s and Treasury’s, along with corporate America. What is the nature of the prevailing financial flows? Answer: Financial speculationchasing yields and inflating securities prices. How stable are the underlying Credit and flow dynamics? Answer: I believe highly unstable and susceptible to changing market perceptions and faltering confidence. What is the role of policymaking and government market intervention? Answer: Profound impact on the markets and real economy. Are there major market misperceptions and resulting mispricings? Answer: Confidence in both ongoing liquidity abundance and the power of central banks has fostered profound systemic mispricing throughout securities and asset markets on a global basis. Is the backdrop consistent with a momentous financial scheme? Absolutely.

Fighting the Fed

Martin Feldstein

JUL 23, 2014
Janet Yellen Ben Bernanke Fed Chairs

CAMBRIDGE The US Federal Reserve is battling with members of Congress over a proposed law, the Federal Reserve Accountability and Transparency Act, that would require the Fed to use a formal rule to guide monetary policy. The Fed fears that the law would limit its independence, while the bill’s proponents argue that it would produce more predictable growth with low inflation. Who is right?
In order to understand the conflict, it is useful to compare the Fed’s independence with that of the Bank of England and the European Central Bank.

In Britain, the BoE has “instrument independence” but not target independence.” The head of the Treasury sets a goal for the inflation rate and leaves it to the BoE to decide which policies will achieve that goal. If the target is missed by more than one percentage point on either side, the BoE’s governor must send an open letter to the head of the Treasury explaining why (and what the Bank proposes to do about it).

By contrast, the Maastricht Treaty tasked the ECB with maintainingprice stability,” but left it free to provide its own operational definition. The ECB defined price stability to be annual inflation of less than but close to 2%. Given the structure of the European Monetary Union, there is no government oversight of the ECB, which thus has both “target independence” and “instrument independence,” though restrictions preclude specific policies.

The Fed is “independent,” but only in a very special sense: vis-à-vis the government’s executive branch. While the US president can instruct administrative agencies like the Commerce Department or the Treasury Department to take specific actions (as long as they do not conflict with valid legislation), the administration cannot tell the Fed how to manage interest rates, reserve requirements, or any other aspects of monetary policy.

But, though the Fed is independent of the White House, it is not independent of Congress. The Fed was created by Congressional legislation that now stipulates a “dual mandate” of price stability and maximum employment. It is up to the Fed to formulate operational definitions of these goals and the policies it will pursue to achieve them. The proposed legislation would affect both “target” and “instrumentindependence.

The Fed decided to define price stability as a “two percent annual inflation over the medium term of the price index of consumer expenditures.” For the past 12 months, that rate of increase has been about 1.5%. While full employment has not been defined, many economists believe it is equivalent to an unemployment rate of about 5.5%. The most recent rate was 6.1%.

Reflecting the fear that the Fed’s current policy of sustained low interest rates will lead to higher inflation, the law would require the Fed to adopt a formal procedure for setting its key short-term interest rate, the “federal funds rate.” More specifically, the law suggests a specific interest-rate rule (the Reference Policy Rule) while giving the Fed the opportunity to adopt a different rule if it explains to Congress why it prefers the alternative.

The Reference Policy Rule is essentially the rule first proposed in 1993 by John Taylor of Stanford University, based on his statistical estimate of what the Fed appeared to have been doing under Paul Volcker and Alan Greenspan during a period of both low inflation and low unemployment. It states that the federal funds rate should be 2% plus the current inflation rate plus one-half of the difference between current and target inflation and one-half of the percentage difference between current and full-employment GDP.

All of this implies that if the economy is at full employment and targeted inflation, the federal funds rate should equal 2% plus the rate of inflation. It should be higher if the inflation rate is above the target level and lower if current GDP is less than the full-employment level.

Given uncertainty about the level of full-employment GDP, this rule still leaves the Fed substantial discretion. The Fed could argue that the gap between current and full-employment GDP is larger than the 6.1% unemployment rate implies, owing to the large number of part-time workers who would prefer full-time employment and the sharp decline in the labor force participation rate. If the GDP gap is 4%, as a recent Congressional Budget Office estimate implied, the Taylor rule would indicate an optimal federal funds rate of about 1.25% (2 + 1.5 – 0.25 – 2), compared to the current rate of only 0.1%.

While the federal funds rate may be heading to 1% over the next 12 or 18 months, by then the narrowing GDP gap will imply an even higher Taylor-rule interest rate. And, complicating things further, given US banks’ vast holdings of excess reserves as a result of the Fed’s bond-buying policies (quantitative easing), the federal funds rate is no longer the key policy rate that it once was. Instead, the Fed will be focusing on the interest rate on excess reserves.

The proposed legislation is full of excessive and impossible requirements, and the Republican-controlled House of Representatives may not be able to pass it, even in modified form. Even if it does, it will not get through the Democratic-controlled Senate. But if the Republicans hold a Senate majority after the next election, some form of legislation requiring a monetary-policy rule could land on the president’s desk. He or she might veto it, but a Republican president after the 2016 election might not.

The Fed no doubt fears that if the principle of requiring a formal rule is accepted, Congress could tighten the requirement, forcing a more restrictive monetary policy. That is why the new Fed chair, Janet Yellen, forcefully opposed such legislation in recent congressional testimony.

One thing is certain: The bill will put pressure on the Fed to pay more attention to inflation, avoiding a persistent rate above its own 2% target. Otherwise, the Fed’s operational independence could be restricted, forcing it to focus its policies more sharply on its inflation mandate.

Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.