Pro-BubbleBy: Doug Noland
The lesson should have been learned by 1994. After a period of extraordinarily loose monetary policy, bloody market chaos was unleashed when the Fed bumped up rates 25 bps (to 3.25%) on February 4, 1994. Treasury and corporate bond markets were clobbered - and leveraged mortgage derivative strategies were obliterated.
At that point, the Federal Reserve should have become focused on the new reality that market-based Credit, leveraged speculation, derivatives and loose monetary policy made for a toxic mix. The Fed needed to have adopted financial stability as a primary objective, with a determination to minimize policy-induced market distortions and fledgling Bubbles. Instead, the lesson drawn from that experience was for the Fed to move even more cautiously and transparently when "tightening" policy.
All the justification and rationalization in the world does not change the harsh reality: The Fed had turned Pro-Bubble and there was, apparently, no turning back.
With Amazon this week up 18.5%, Microsoft 15.0%, Starbucks 8.9%, Lam Research 8.6% and Google 7.8% - and NASDAQ surpassing year-2000 highs (up 290% from 2009 lows!) - my thoughts returned to the forces underpinning the late-nineties Bubble period. The year 1998 was critical. It's worth recalling that NASDAQ was up 28% y-t-d through July 20, 1998. The Bank index had surged 27%, with the S&P500 gaining 22% through mid-July. Markets were Bubbling in spite of unfolding global turmoil. To be sure, there are important parallels to the current backdrop.
In the face of growth that had accelerated to 4.5% in 1997, the Fed maintained its tightening bias yet refrained from adjusting rates up from the 5.5% level set in March 1997. Financial sector Credit was expanding rapidly and general Credit conditions were loosening. Yet the "Asian Tiger" collapse and other global instabilities were weighing on the Fed. A fledgling "tech Bubble" took complete advantage.
After beginning 1995 at 752, the NASDAQ Composite traded at an intra-day high of 2,028 on July 21st 1998. Bubble Dynamics were on display throughout 1998 - including a show of how quickly air could escape. NASDAQ lost a third of its value in less than three months (July 21 to October 8), trading to a low of 1,357 at the height of the Russia/LTCM crisis. Demonstrating that the Fed was much more concerned with bursting Bubbles than inflating ones, rates were cut from 5.5% to 4.75% in a two-month period (Sept 29 to Nov. 17).
The Fed orchestrated an extraordinary bailout of the hedge fund Long Term Capital Management (LTCM), less than four years after global crisis fears spurred the Mexican bailout. NASDAQ then proceeded to rally 62% in less than three months to trade above 2,200 during 1998's final trading session. NASDAQ ended 1999 at 4,091 and then reached its cycle peak at 5,133 on March 10, 2000. Not until late-1999 did Fed funds even make it back to the pre-crisis 5.5% level.
Fed rate manipulations and market distortions remain integral to Bubble Dynamics. Global fragilities remain fundamental as well. Back in the late-nineties, an unsettled backdrop kept the Fed from tightening what was clearly dangerously loose U.S. monetary and Credit conditions. While few at the time appreciated the underlying finance inflating the Bubble, the sources were not difficult to discern at the time.
GSE balance sheets expanded an unprecedented $151bn in 1994, $305bn in 1998 and $317bn in 1999. During the six-year period 1994 through 1999, GSE assets surged $1.092 TN, or 173%, to $1.723 TN. Total GSE Securities (borrowings and MBS) over this period ballooned $2.009 TN, or 105%, to $3.916 TN. In a transformative market development, the GSEs assumed the role as reliable market liquidity backstops, willing and able to aggressively intervene in the markets during period of market stress.
The U.S. dollar index ended 1995 at 84.76. Between the Fed's Pro-Bubble "asymmetrical" policy approach, GSE market backstops and heightened global fragilities, few global markets could compete with the risk vs. reward profile enjoyed by U.S. securities markets. The dollar index ended 1999 at almost 102 and peaked in 2000 at about 119.
"King dollar" "hot money" and foreign investor buying were key sources of demand for booming U.S. securities markets. Corporate borrowing surged 8.6% in 1997, 10.8% in 1998, 9.6% in 1999 and 8.3% in 2000. Much of corporate borrowings were high-risk loans feeding the technology Bubble. With NASDAQ fueling historic wealth accumulations, a torrent of liquidity was inundating the market and technology industry.
At the time, the bullish American "New Era" and "New Paradigm" mottos were compelling (parallels to today). Yet it was clear to me at the time that the finance fueling the Bubble was unsound and unsustainable. Bubbles burst. And that was the fate awaiting NASDAQ, the corporate debt market and king dollar. Anyone discussing such a fate in 1999 was considered a hopeless lunatic.
While also pertinent to the current Bubble backdrop, I'll avoid rehashing the analysis of the unsound finance that fueled the mortgage finance Bubble. In short, mortgage debt doubled in less than seven years. There was huge growth in (to name a few) the broker/dealers and speculator leveraging. There was spectacular expansion in "repos," special purpose vehicles (SPVs), Eurodollar borrowings, the ABS marketplace and derivatives (subprime CDOs!).
Underpinning the historic expansion of Credit and mortgage risk was the market view that Washington would never allow a housing bust. Very few at the time saw serious issues. And it all appeared sustainable - that is so long as housing prices continued to inflate.
After failing to heed the lessons from 1994 and 2000 experiences, we shouldn't have been surprised by another failure. The number one lesson global policymakers gleaned from the 2008 debacle: Lehman Brothers should never have been allowed to fail. Somehow, Trillions of high-risk loans, Trillions of leverage, Trillions of fraud/corruption, Trillions of mispriced securities, and resulting unprecedented economic maladjustment could have been sustained had Lehman been bailed out (a modern version of "the Great Depression could have been avoided had the Fed recapitalized the banking system."). Given determination and some time, it's always possible to inflate out of debt troubles. Really Dangerous Thinking.
So global policymakers have come to believe that Bubbles can be accommodated - even used as a policy tool. Market perceptions can be readily manipulated - and the Fed has a role, a moral obligation to do so. Market risk aversion, liquidity and tumult can be expertly managed. Do whatever it takes to assure the markets that crisis will not be tolerated. Act with sufficient resolve to ensure the speculator community bets with policy and not against it. Above all, guarantee abundant, uninterrupted cheap marketplace liquidity. And this all goes directly counter to what I believe is the critically important analysis of our times: There is no alternative but to develop a systematic approach to suppressing Bubbles - and the earlier the better.
Here in the U.S., there's been zero effort to downsize the GSEs. Despite the Trillions that have flowed into "bond" funds, ETFs and risk assets more generally, the Fed has made no attempt to extricate itself from crisis-period market manipulations and move toward a more normalized risk market backdrop. Leveraged speculation has never been so popular. The marketplace for Credit and market derivative "insurance" poses as big a systemic risk as ever. Arguably, securities markets have never been so distorted.
Today's policy debate centers on when to commence transparent, slow-motion little baby step rate increases - and on the eventual pace of reducing the Fed's bloated balance sheet. It's all Pro-Bubble.
The critical issue is the market perception that the Fed will immediately reemploy QE at the first sign of market tumult. This is the fundamental Pro-Bubble Market Distortion that desperately needs to be addressed and rectified (reminiscent of the Pro-Bubble market perception that the Treasury and Fed would back GSE obligations that was at the heart of mortgage finance Bubble excesses). Why would market participant fret inflating Bubbles when they only increase the probabilities of additional QE?
Central to Credit Bubble Theory is the view that systemic risk rises exponentially during the "Terminal Phase" period of Bubble excess. Policymakers are on a fool's errand when they set a policy course to patiently and innocuously deflate a Bubble. After all, bailing out Lehman would have only led to a bigger Bubble. "Kicking the can" on an insolvent Greece has only worsened a really bad situation. Draghi's QE is Pro-securities Bubbles and is only worsening systemic fragility. Reckless BOJ QE is setting the stage for collapse. Meanwhile, no one is working more diligently to manage a runaway Bubble than the Chinese.
A Thursday evening Bloomberg headline resonated: "If China Sees Capital Outflows Now, What Happens in Crisis?" Considering the scope of Credit excess; an unprecedented Bubble in shoddy apartments; massive corruption and historic economic maladjustment, there's a stunning lack of concern for China's faltering Bubble. Another Bloomberg headline was direct and spot on: "China Has a Massive Debt Problem."
The aged global Bubble is in a precarious late-phase dynamic (that somehow passes for financial nirvana). Having survived previous scares, close calls, panics and even deep crises, the world has grown convinced that policymakers now have everything under control. "Money" printing works. Manipulating securities markets (for the greater good) has become adeptly refined. Moreover, when it comes to China and the Chinese Bubble, they have $3.7 Trillion of reserves - a horde easily capable of stimulating the economy, recapitalizing its banking system and accommodating financial outflows as necessary.
If my analytical framework is sound, Chinese policy is only exacerbating Bubble fragility. In the short-term, fiscal and monetary stimulus has sustained growth in incomes, spending and GDP. The bursting of the Chinese apartment Bubble has for the most part been held at bay.
Yet China will likely have another year of better than $2.0 Trillion of Credit expansion. They'll have another year of millions of new apartments and industrial capacity to add to already gross oversupply. This late-cycle Credit is of especially poor quality - much of it is financing inflated apartment markets, suspect local government borrowings and a whole host of enterprises and ventures that will prove uneconomic come the bursting of the Chinese and global Bubbles (if not sooner).
Importantly, much of this "Terminal Phase" Credit is being heavily intermediated through "wealth" and special-purpose vehicle, investment funds and other savings vehicles. As is typical during a Bubbles initial tottering phase, investors and speculators become captivated by what are perceived as attractive yields and returns. And the longer the "Terminal Phase" is extended, the more suspect debt that is created and the more of it that is accumulated by the unsophisticated and unsuspecting. And I would strongly argue that this deleterious dynamic is exacerbated by the policy-induced global yield collapse, including an estimated $3.0 Trillion of sovereign debt that now trades with negative yields.
It is this divergence between the expanding quantities of unsound Credit and the rising accumulation of perceived safe ("money-like") wealth that sets the stage for the inevitable crisis of confidence. Policymakers just have not learned: The Alchemists still believe they can inflate bad debt into good. Invariably, notions of cautiously reining in a Bubble meet the reality of the extraordinary impairment wrought upon system stability over relatively short periods of "Terminal" excess. The Shanghai Composite's nine-month, 90% moonshot is testament to the hazard of accommodating late-cycle Bubbles.
April 23 - Bloomberg (Ting Shi): "From "Lord Ringtone" to a banker accused of authorizing $1.6 billion in illegal loans, China's list of most-wanted fugitives offers an illustrated guide to the Communist Party's breathtaking variety of official graft. The online rogue's gallery of 100 top overseas corruption suspects was released by Chinese authorities to pressure the U.S. and other governments to help track down and return them... The list spans China's industries, from finance and property to oil and car manufacturing. There are former representatives of the state-controlled news media and one ex-history professor. The campaign to repatriate financial fugitives -- dubbed "Sky Net" -- is key to President Xi Jinping's nationwide corruption crackdown, with some 40 people on the list released Wednesday thought to be in the U.S."
Some estimates have over $1.0 Trillion of corrupt "money" having fled China. How much has made it to U.S. real estate and securities markets? For that matter, how much global finance Bubble "dirty money" has made its way to America? How much legitimate wealth has escaped local fragility for greener U.S. pastures - from China, Russia, Brazil, Venezuela, Latin America, Europe and the Middle East? And how much "hot money" has been unleashed by respective QE currency devaluations from the Bank of Japan and European Central Bank? How big are global leveraged "carry trades"? What have been the impacts and what are the ramifications from these historic flows that I view as unsound, unstable and unsustainable?
By this point, things have gone way beyond the late-nineties "king dollar" dynamic. Recent years have seen unprecedented global flow instability - literally Trillions flowing to and fro in an unremitting chase for returns. The closest parallel is the profoundly unstable global backdrop from the late-twenties. And like the "Roaring Twenties," few today appreciate how deeply systemic all the unsound finance has become - not with stocks at record highs, bond prices at record highs and household net worth at all-time highs.
"Tech" Bubble fragility was exposed when NASDAQ reversed course and plummeted back in 2000. Mortgage finance Bubble fragility was unmasked when housing prices declined. And I fully expect global government finance Bubble fragilities to emerge when the world's overheated risk markets inevitably come back to earth. And when it comes to market Bubbles, it's often the final parabolic move that sets the stage. The NASDAQ 100 gained 4.5% this week - playing a little catch up with Bubbles in China, Europe, Japan and even EM more generally.