Houston, We Have a Bubble Problem
Doug Nolan
Aged.
Unhealthy and deeply unsound.
Worryingly unstable.
Many voice serious concerns in private, with only a few willing to publicly broach the subject.
But it’s way past time to have an open and candid debate on such critical subject matter and how to move forward.
And I’m not referring to Nancy Pelosi and Barack Obama venturing to the West Wing for a heart-to-heart with President Biden.
Bubbles have been momentous market and economic phenomena for centuries.
The Dutch “tulip-mania” (1634-1637) is often cited as the first well-documented Bubble.
Inflating after John Law’s introduction of paper money to France, the Mississippi Bubble (1719-1720) was a spectacular Credit, speculative and economic Bubble fiasco.
Inflating during the same period in the UK, the South Sea Bubble had similar disastrous consequences.
There was the great U.S. (1866-1873) and UK railway Bubbles and busts.
“Roaring Twenties” Credit and speculative Bubbles laid the groundwork for the 1929 crash and Great Depression.
Castigating the “Bubble poppers” (who at the time recognized the unfolding peril), the revisionist Ben Bernanke shifted blame for the depression to the Fed’s negligent failure to print sufficient money.
But we don’t have to resort to history books to appreciate the critical importance of Bubble analysis.
Japan still suffers the consequences of its eighties Bubble period more than three decades later.
The 1995/98 collapses of the Mexican, Asian Tiger and Russian Bubbles were catastrophic.
Then there was the so-called “dot.com” Bubble.
More recent yet, the so-called “great financial crisis” was the fateful consequence of bursting Bubbles.
The commonly labeled “housing Bubble” was more accurately a phenomenal mortgage finance Bubble.
That historic Bubble encompassed massive expansions of mortgage Credit, GSE balance sheets, outstanding MBS, derivatives, hedge fund leverage, and a plethora of “shadow bank” mortgage lenders, not to mention traditional bank lending.
It was as if obvious lessons from that terrible experience were all simply washed away in a sea of reflationary monetary policymaking.
I didn’t hear the word “Bubble” in two days of Powell’s back and forth testimony with members of Congress.
“Bubble” was not uttered once during Powell’s May 1st or March 20th press conferences.
It’s arguably today’s most important and pressing issue for the markets and economy, yet the subject of Bubbles has curiously reached the point of complete radio silence.
As much as I’ve been a longtime admirer, I find myself increasingly annoyed with Mohamed El-Erian.
From his FT piece this week, “What the Federal Reserve Should Put on the Jackson Hole Agenda.”
“Remember the Asian financial crisis, the shock from the LTCM hedge fund blow-up, the Russian debt default and the Lehman collapse?
They all came to a boil during summer.
Yet when there are fewer financial fires to be put out, central banks have found the season to be a good time to take stock of where their policies stand and where they would like them to go…
It is my strong hope… that the Fed’s cadre of capable PhD economists and other policy wonks will be deliberating on a set of issues that are key to America’s economic wellbeing and global financial stability…”
“What are these issues?
Here is my list:
First, why did Fed forecasts get it so wrong, be it on inflation or unemployment…
Second, ongoing structural and secular changes in how the US and global economies function are more consequential for policy design than ‘noisy’ short-term data…
Third, given that the 2020 revisions to the Fed’s monetary policy framework were out of date almost on publication and potentially harmful, is there not an urgent need for an acceleration of the review of it?
Fourth… what is the appropriate inflation target, and what is the level of the neutral interest rates where monetary conditions are not too tight or loose?
Fifth, is it not now time for the Fed to put much greater emphasis on the risk of unduly damaging the real economy and employment…
Six… is it not time to consider moving to the Bank of England’s practice of appointing outside experts to the Federal Open Market Committee…”
All major equities indices have surged to uncharted territory.
The Nasdaq100 has returned 36% in nine months – having doubled from 2022 lows.
The Semiconductors (SOX) have a nine-month return of 66.6% (184% off ’22 low), with Nvidia up 179% in three quarters (up more than 10-fold from ’22 lows).
The S&P500 has returned 31.4% in nine months and is up 62% from September 2022 lows.
The federal government continues with a string of historic fiscal deficits, sustaining highly elevated system Credit growth.
Despite the Fed boosting rates to 5%, myriad indicators point to ongoing loose financial conditions.
Ten-year Treasury yields dropped 10 bps (to 4.18%) this week to lows since March, with MBS yields sinking 21 bps (5.52%) to within a basis point of lows back to early-February.
Corporate yields and CDS prices also traded this week back to March levels.
I expect booming markets and this week’s looser conditions to underpin the economy.
It's been a rather conspicuous Credit Bubble and speculative melt-up, with AI a historic global mania, arms race, and multifaceted Bubble.
The appropriate course of monetary management in such an extraordinary backdrop is such a critical issue, certainly worthy of Jackson Hole Economic Symposium consideration.
Revisiting the August 2008 “Maintaining Stability in a Changing Financial System” theme would be opportune.
While the economic community in August 2008 had no idea what was coming, they at least recognized that the subprime crisis had Bubble ramifications.
Indeed, the introductory paper for the conference, “Maintaining Stability in a Changing Financial System – An Introduction to the Bank’s 2008 Economic Symposium,” by Gordon H. Sellon, Jr. and Brent Bundick, included three Bubble references.
First, “Should central banks respond more symmetrically to asset-price or credit bubbles?”
Second, “In noting the similarities of the current crisis to the recent Japanese experience, [Bank of Japan’s Yutaka] Yamaguchi also suggested it was time to reconsider whether central banks should move away from the conventional wisdom that they should only clean up after a financial crisis but not actively resist the buildup of credit bubbles.”
And third, “Several symposium participants also noted that ‘macro-prudential’ supervision and regulation, which has been advocated by the Bank for International Settlements (BIS) for many years, may be an alternative to using monetary policy to prevent the formation of credit and asset-price bubbles.”
Fourteen years later, these three issues are more critical than ever.
The evolution of the Fed’s asymmetrical approach (dating back to Greenspan) lurched to previously unimaginable extremes with the Fed’s $5 TN pandemic monetary inflation.
“Whatever it takes” regressed to completely open-ended Treasury and MBS (and ETF) purchases, creating a unique ironclad liquidity backstop to be exploited by the leveraged speculating community.
Little wonder Treasury “basis trade” leverage is said to now exceed $1 TN.
The current Bubble dwarfs mortgage finance Bubble excess.
For starters, home prices have inflated about 50% since the pandemic.
But even greater excess has pushed equities prices to historic extremes.
System Credit growth significantly exceeds previous peak cycle levels.
“Private Credit” has doubled since the pandemic to surpass $2.0 TN.
Buy now, pay later “phantom debt” has also expanded rapidly.
The market capitalization of cryptocurrencies inflated to over $2.5 TN.
Safeguarding financial stability in an environment of ubiquitous Bubble excess presents major challenges for central bankers.
The steep cost of cleaning up after burst Bubbles was at least partially revealed post-2008.
With reflationary policies then inflating the ongoing global government finance Bubble, the tab on post-Bubble cleanup continues its exponential rise.
The Fed (and other central banks) adopted a doctrine of distancing monetary policy from Bubble containment, choosing instead to apply “macro-prudential” measures to thwart asset inflation and speculative Bubbles.
This cop-out approach was destined for failure, of which the March 2023 banking crises offered an early “progress” report.
Ironically, with everything Bubbles now inflating everywhere, the Fed no longer bothers with the pretense of a functioning macro-prudential framework.
If you’re going to succumb to printing $5 TN and holding rates at zero for years, at least double-up on macro-prudential regulatory oversight.
Essentially, the Fed, economic community, Wall Street, Washington, and the financial media today simply disregard all things Bubble.
To be sure, ignoring Bubble dynamics and analysis creates a major analytical handicap.
How could the Fed have been so wrong on inflation?
They failed to recognize the nature of the Bubble they had unleashed.
Why have Credit, financial conditions, economic growth, and pricing pressures all proved so resilient in the face of a sharply higher policy rate?
Bubble Dynamics.
Why has it been such a struggle for economists to pin down the so-called “neutral rate”?
Because the impacts of a particular policy rate will vary profoundly, depending on the prevailing status of the Bubble.
This is especially the case late in the Bubble cycle, where the thinnest lines separate the parabolic “Terminal Phase Excess” from Bubble deflation.
Mr. El-Erian and others have issues with the Fed’s meeting-by-meeting data dependency.
Having left Bubbles to run wild, the Federal Reserve is now on the tiger’s back.
They surely have come to appreciate the persistence of loose conditions, asset inflation and economic demand.
Moreover, the Fed certainly wants to avoid popping Bubbles.
So, they have no alternative other than attentive observation and to pray things don’t go off the rails.
The more entrenched a Bubble, the more impervious it will be to well-telegraphed increases in the policy rate.
The Fed made a major policy blunder in signaling the end of its “tightening cycle” despite ongoing powerful Credit growth, speculative excess, and asset inflation.
Powell and Fed officials kept talking restrictive monetary tightening in the face of a major Bubble-bolstering loosening of financial conditions.
I can hear it already.
A big “I told you so!” from the likes of El-Erian and others.
Bubbles inevitably burst.
When today’s historic Bubble finally begins to succumb, the Wall Street crowd will insist the Fed raised rates too aggressively and stuck with excessive tightening for far too long.
And I’m sure this deeply flawed analysis will resonate, just as Bernanke’s revisionist attack on the late-twenties “Bubble poppers” and a bumbling Federal Reserve did following the bursting of the tech/dot.com Bubble.
The Fed desperately needs an analytical framework and explainable policy approach for dealing with Bubbles.
Bubbles pose potentially monumental risk to financial and economic system stability - and certainly shouldn’t be ignored.
Simply waiting patiently for them to flame out is a recipe for disaster.
After all, tremendous systemic damage can be inflicted in relative short-order during “Terminal Phase Excess” – particularly throughout a historic multi-decade super-cycle “blow off” topping process.
July 11 – Wall Street Journal (Katherine Blunt, Jennifer Hiller and Benoît Morenne):
“Across this city’s famous suburban sprawl, drivers for the fourth straight day are inching through intersections without working traffic signals.
With a brutal heat wave settling over the region, residents are piling into ‘cooling centers’ to charge their phones and soak up air conditioning they no longer have at home.
And just about everyone is wondering why—in the country’s fourth-largest city, which calls itself the energy capital of the world—widespread power outages like this keep happening.
Most of the questions are pointed at CenterPoint Energy, which has spent nearly $1.5 billion in recent years to make Houston’s power grid more resilient…
Hurricane Beryl… was the latest event to show how the combination of continued population growth and increasingly extreme weather is proving difficult to overcome.”
July 10 – Associated Press (Juan A. Lozano and Jim Vertuno):
“Houston’s biggest utility came under mounting pressure Wednesday over its response to Hurricane Beryl, as nearly 1.4 million area homes and businesses remained without power and residents searched for places to cool off, fuel up and find something to eat.
City Council member Abbie Kamin called the extended lack of power a ‘life safety concern.’
‘We say ‘everything we can do’ to get the lights back on.
In my opinion, respectfully, they should be on,’ Kamin told a CenterPoint Energy executive during a council meeting.
‘This was a Category 1 (storm),’ Kamin said, referring to the weakest type of hurricane.
‘We know that this severe weather, the extreme weather due to climate change, is real and we’ve known for some time.’”
July 9 – Bloomberg (David R. Baker and Kevin Crowley):
“Houston is struggling through Hurricane Beryl’s chaotic aftermath, with blackouts, blocked roads, internet disruptions and spotty access to gas expected to linger well after the storm’s floodwaters recede…
The outages, which at their peak cut power to more than 2.5 million customers across the region, disrupted service at cell phone towers, traffic lights and a major data center, while leaving residents to swelter through a heat wave.
Many sought the shelter of air-conditioned hotel rooms only to find the properties either blacked out or booked solid.”
One of the great ironies of Bubbles was on subtle display this week, offering an opportunity to turn analytical concepts into tangible reality.
The perception is one of an era of incredible wealth creation.
The reality of Bubbles is something different: pernicious resource misallocation, deep structural maladjustment, and true wealth destruction.
For the most part, malign Bubble effects remain concealed awaiting the inevitable bursting.
There are, however, occasions that offer an inkling of the future.
As I write on Friday evening, there are still a million customers (residential and business) still without power in Southeast Texas.
Houston utility Centerpoint has warned that “roughly 500,000” will be out of power into next week.
A frightening number suffered this week through a heat index exceeding 100 degrees without electricity.
Houstonians have every reason to be outraged.
It’s easy to confine blame largely to Centerpoint.
But Houston’s crisis this week is a microcosm of a greater calamity in planning, prioritization, and resource allocation.
Houston was hit by Hurricane Ike in 2008 and the devastating Hurricane Harvey in 2017.
This past May, the city was slammed by a powerful derecho.
That the fourth largest city in the U.S. was brought to its knees this week by a Cat 1 hurricane should be a wake-up call.
As a nation, we are woefully unprepared for increasingly extreme and erratic weather.
Unlimited resources have been available for bitcoin mining infrastructure, data centers, all things AI, tech, and the like.
Meanwhile, our desperately deficient power grid puts lives and economic well-being at increasing risk.
The Texas power grid has been under notable stress, with over four million homes and businesses losing power during the 2021 ice storm (with hundreds of deaths).
Huge investment to strengthen system resilience against cold weather, neglected vulnerability to wind and flooding.
Houston, at heightened risk of hurricanes and floods, faces a particular challenge in energy infrastructure.
The deteriorating climate backdrop will require massive investment for Houston, Texas and basically the entire country.
The AI/data center mania and arms race are particularly ill-timed.
On the one hand, it gobbles up investment dollars, while placing further demands on already stretched energy infrastructure.
Under the Friday headline, “Hurricanes, Extreme Heat Form Insidious Combo,” Axios’ Andrew Freedman writes:
“The lack of power to hundreds of thousands of Houston residents for the fourth straight hot and humid day since Hurricane Beryl struck the city is creating dangerous — and in some cases deadly — conditions…
With global average temperatures on the increase, along with the likelihood and severity of heat waves, society is increasingly vulnerable to this type of one-two punch of an extreme weather disaster…
The heat wave and hurricane relationship is no accident.
Hurricanes are often followed by hot and humid air masses…
In addition, climate change is not only supercharging hurricanes in certain ways, but it is also altering heat wave characteristics.
‘This hurricane season is already forcing us to face some difficult realities,’ says Steve Bowen, chief science officer for Gallagher Re.
‘Our aging infrastructure has largely been built to meet the demands of a 20th century climate that no longer exists…
As more people migrate into known high-risk communities, it puts further strain on grids that need to be modernized.’”
Bubbles are incredibly engrossing.
We’ll just buy Nvidia, get rich, and live happily ever after.
When this Bubble bursts, we’ll face the reality of what a fiasco this has all become.
Epic delusion and denial.
I was thinking of using “ironic,” considered “really bad luck,” and settled on “only fitting.”
True to the nature of end-of-cycle craziness, it’s only fitting that an energy guzzling AI Bubble would emerge as heat and climate extremes become a pressing global issue.
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