FAILED / CREDIT BUBBLE BULLETIN

Failed

Doug Nolan 

I often find my thoughts returning to the great German economist, Dr. Kurt Richebacher. 

This week, it was his analysis that inflation comes in various forms, with his argument that asset inflation was the most pernicious. 

It was such a minority view, seemingly unique. 

As he would explain, consumer price inflation is commonly recognized as destructive. 

Rising consumer prices will invariably upset the public, business community, politicians, and central bankers. 

Sure enough, there was overwhelming support for the Fed’s effort to rein in consumer price pressures.

Meanwhile, asset inflation is universally relished, viewed generally as validation of sound underlying fundamentals. 

There is no anti-asset inflation constituency to exert influence over policy. 

Especially these days, there is nothing to suggest the Fed would adopt tighter monetary policy to thwart assets inflation, speculation, and Bubbles. 

Indeed, at this last cycle stage, it’s assumed that supporting rising market prices is a primary responsibility of the Federal Reserve and global central bank community.

History teaches that the greatest crises unfold after the bursting of major asset and speculative Bubbles. 

The bursting mortgage finance Bubble and “great financial crisis” are not yet distant history. 

Even greater Credit and financial excess - and resulting deep structural maladjustment - were responsible for the Great Depression.

Another historic asset Bubble calamity is top of mind. 

The Bank of Japan (BOJ) meets next Tuesday. 

The market has a 56% probability of the BOJ boosting rates above zero, effectively ending the negative rate experiment with the first rate increase since 2007.

Japan’s deep structural issues can be traced directly back to the nation’s spectacular eighties asset Bubble. 

As is typically the case, Japanese asset inflation and speculative Bubbles unfolded in a low policy rate environment, with tame consumer price inflation having deluded central bankers into a false sense of prowess and control.

After 25 years of post-Bubble stagnation, the BOJ in 2013, under the leadership of Governor Haruhiko Kuroda (and Ben Bernanke prodding), adopted an experimental policy course of radical inflationism. 

Having ended 2012 at 158 TN yen, Bank of Japan assets inflated 379% to 759 TN yen, or $5.162 TN. 

If negative rates weren’t enough, the Kuroda BOJ also imposed a yield curve control (YCC) regime that pegged government bond yields to near zero percent.

March 15 – Bloomberg (Erica Yokoyama and Yoshiaki Nohara): 

“Japan’s largest union group announced stronger-than-expected annual wage deals Friday, a result that will fuel already intense speculation that the central bank will next week raise interest rates for the first time since 2007. 

Rengo, a federation of unions, said its members have so far secured deals averaging 5.28%, a figure that far outpaces the initial 3.8% tally from a year ago — itself the biggest in 30 years. 

Many of Rengo’s affiliated groups had already announced agreements to hike wages by 5% or more.”

With 5% wage boost labor contracts and a yen near lows back to 1990, I guess Governor Kazuo Ueda can soon declare mission accomplished. 

Meanwhile, the Nikkei 225 Index has inflated about 50% since the end of 2022, trading to record highs for the first time since Bubble year 1989. 

Reminiscent of the late eighties, spectacular Tokyo condo price inflation has made housing unaffordable for most. 

The IIF places Japanese government debt at 230% of GDP.

It should be incontrovertible that central banks must remain conservative and principled institutions. 

Too much is at stake to ever play fast and loose. 

Major policy errors are not only destructive, they predictably lead to only more momentous blunders. 

Drifts or shifts into experimental and radical policymaking signal something has gone wrong. 

I’ve always had issues with the likes of Bernanke, Draghi, and Kuroda. 

They never seemed interested in exploring the root causes behind the bursting Bubbles that provoked their radical monetary inflationism.

Today, at manic peak Bubble bullishness, most everyone (if they were familiar with my analysis) would see my efforts as a comical foul’s errand. 

Lunatic fringe fear-mongering. 

Yet I remain convinced that inflationism is the fool’s errand. 

The inflation of non-productive “money” and Credit is definitely the problem, not the solution. 

Zero and negative rates, Trillions of “money printing,” and epic market manipulation only inflated history’s greatest Bubbles - while exacerbating epic global structural maladjustment. 

The scope of China’s policy failures is coming into clearer focus. 

The failure of BOJ’s foray into radical inflationism will be revealed as Japan begins a process of normalization fraught with peril.

Federal Reserve policymaking is these days celebrated as pure brilliance. 

They’ve reined in inflation, while asset prices have continued to rise. 

Stocks have surged to record highs, home price inflation has been ongoing, and corporate bond returns have been solid. 

The Fed has accomplished monetary tightening without imposing costs on labor or the economy. 

If it seems too good to be true…

The Fed has failed. 

This dreadful reality is masked by a facade forged from loose conditions, asset inflation, and speculative Bubbles. 

And this sounds so lunatic fringe for a simple reason: I don’t share today’s universal adoration for loose financial conditions.

Recalling William McChesney Martin’s great insight: “It’s the job of the Federal Reserve to take the punch bowl away before the party gets going.” 

There is profound wisdom in this witty quote, one whose resonance has diminished over the decades of central bank largesse. 

Get control early or face debilitating societal consequences.

To assert Fed failure today is to beckon for lunatic designation. 

But I’ve seen it all before. 

Mark my words. 

After the Bubble bursts, it will have been apparent to all.

The Fed has Failed thesis can be boiled down to a few key points. 

Our markets, financial system, and economy have been at extraordinary risk, acutely susceptible to late-cycle Credit excess, asset inflation, and extreme speculation. 

Yet the Fed is negligently impotent. 

Instead of “leaning against the wind” with tighter monetary policy, the Federal Reserve signaled a “dovish pivot” to rate cuts with the highly speculative markets in the throes of blowoff excess.

In short, the Fed is today incapable of tightening financial conditions in an environment where tighter conditions are fundamental to monetary stability, sound assets markets, and stable price levels across the economy. 

And I am familiar with the arguments against tightening: it would further boost debt service costs and federal debt, harm market function, hit over-levered households and businesses, and unleash recessionary forces.

I certainly appreciate today’s late-cycle fragilities. 

Yet they are the inevitable consequence of years of monetary mismanagement. 

Perpetual loose conditions progressively subverted market discipline. 

Only the bond market could have forced a semblance of fiscal prudence out of Washington. 

Instead, years of artificially low rates and massive QE programs accommodated a drift toward reckless deficit spending. 

Despite booming markets and solid economic growth, intractable Washington profligacy will ensure a 2024 fiscal deficit of around 7% of GDP.

Tighter conditions would be problematic for highly levered bond markets. 

It would be painful for government, business, and household sectors. 

It would force much needed and inevitable deleveraging, in highly speculative markets and throughout the real economy. 

Unfortunately, pain would be inflicted upon over-levered speculators, business enterprises, and households.

A regretful amount of pain is the comeuppance for years of central bank subversion of market forces. 

Importantly, thwarting adjustment in a capitalistic system ensures greater future pain. 

As Dr. Richebacher used to say: there is no cure for a Bubble, only not to let it inflate. 

Years of accommodating and resuscitating Bubble excess got us to where we are today: a Fed that completely disavows responsibility for containing financial excess and Bubbles.

When I ponder the essence of the Fed’s failure, my thoughts return to analysis of the success of gold standard monetary regimes. 

An environment of relative stability was not simply the fruit of pegging the money supply to a somewhat fixed quantity of gold. 

Policy makers, bankers and industrialists were both committed to the system and understood that prudent behavior was fundamental to its sustainability.

Importantly, financial operators and speculators understood that policymakers would respond to fledgling excess with the resolve necessary to safeguard the stability of the monetary regime. 

This mindset and value system worked to restrain the self-reinforcing dynamics inherent in Credit and speculative excess. 

When things began to get overheated, players showed restraint with the knowledge that policymakers were prepared to impose painful tightening measures. 

The gold standard system had inherent mechanisms that disincentivized pro-Bubble behavior.

The contemporary central bank policy regime failed specifically because it incentivized myriad excesses. 

There is only upside for Washington politicians to spend lavishly and run up massive deficits. 

Businesses and households borrow irresponsibly, knowing that the Fed will ensure that the economy quickly recovers from any shock or downturn. 

Bankers and lenders lend aggressively, knowing the Fed (and GSEs) have their backs. 

Households can speculate in stocks and options, confident that the Fed backstop ensures ever higher equities prices. 

And, importantly, the enterprising leveraged speculating community pushes the envelope with leverage and risk-taking, enticed by incredible fortunes for the taking - and confident that the greater the degree of excess (and resulting fragility), the more zealously the Fed (and central bank community) will ensure liquid and inflating markets. 

In short, self-reinforcing Credit and speculative excess are powerfully incentivized, ensuring ever deeper financial and economic structural maladjustment.

It's a monetary regime doomed to fail. 

That policymakers resorted over the years to zero/negative rates, Trillions of “printing,” and egregious market interventions is at the heart of why my world view diverges so diametrically from others.

Two-year yields jumped 25 basis points this week. 

The market closed Friday pricing a 4.61% policy rate at the Fed’s December 18th meeting, up 23 bps on the week. 

This implies almost three rate cuts (72bps) by year-end, with the market now seeing only a 61% probability of a cut by the June 12th FOMC meeting.

Basically, the market is aligned with the median three cuts signaled by the December “dot plot.” 

A new “Summary of Economic Projections” will be forthcoming Wednesday. 

And it’s becoming a habit. 

This week saw CPI and PPI reports with higher-than-expected inflation. 

One might expect some FOMC members to adjust inflation and growth expectations higher, while reducing the number of projected 2024 cuts.

March 11 – Reuters (Lewis Jackson and Stella Qiu): 

“JPMorgan… CEO Jamie Dimon… urged the Federal Reserve to wait until after June before cutting interest rates, arguing the central bank needs to shore up its inflation-fighting credibility. 

‘I think they have to be data-dependent. 

If I were them, I would wait,’ Dimon said… ‘You can always cut it quickly and dramatically. 

Their credibility is a little bit at stake here. 

I would even wait past June and let it all sort it out.’ 

Dimon said the U.S. economy was doing so well it could almost be characterised as a boom, but cautioned against the wholesale embrace of the soft landing narrative by markets… 

Dimon said the surge in debt and equity markets since late 2023 had some bubble-like characteristics and linked it in part to the legacy of the pandemic-era fiscal and monetary stimulus, which was ‘still in the system, you can’t say that they’re gone’.”

March 12 – Bloomberg (Katherine Doherty): 

“Citadel founder Ken Griffin said the Federal Reserve should move slowly in lowering interest rates to avoid the possibility of having to reverse course later. 

‘Pausing and then changing direction back toward higher rates quickly, that would, in my opinion, be the most devastating course of action to pursue,’ Griffin said… at the Futures Industry Association conference... 

‘So I think they’re going to be a bit slower than people were expecting.’”

We’ll pay close attention to Jamie Dimon and Ken Griffin. 

They are two of this extraordinary era’s preeminent financial operators, successfully operating their financial alchemy from the most advantageous of catbird seats. 

I suspect they’re concerned that things could become unhinged with rate cuts. 

The Fed’s credibility is at stake.

Powell’s press conference should be interesting. 

It would be appropriate for “Balanced Powell” to rectify his recent dovish lean. 

Stocks and bonds appear increasingly vulnerable. 

The holes in the bullish narrative are increasingly difficult to deny. 

Curious to see commodities start to perk up. 

And didn’t Nasdaq trade to highs around the March 2000 quarterly options expiration, a record high that held for 15 years.