LOOK BACK IN ANGER / CREDIT BUBBLE BULLETIN

Look Back in Anger

Doug Nolan

October 16 – Wall Street Journal (Alan S. Blinder and Mark Zandi): “Don’t Look Back in Anger at Bailouts and Stimulus… Logic dictates that the size of any stimulus be proportional to the expected decline in economic activity—which was enormous in the Great Recession. The Recovery Act and other stimulus measures were costly to taxpayers, and thus much-maligned. But the slump would have been much deeper without them. The Federal Reserve has also come under attack for its unprecedented actions, especially its quantitative easing or bond-buying programs. Yet QE lowered long-term interest rates and boosted stock and housing prices—all to the economy’s benefit. Yes, QE has possible negative side-effects, but for the most part they have yet to materialize. Policy makers who botched the regulatory job before the crisis and shifted to fiscal restraint prematurely in 2011 can hardly be considered flawless. Yet one major reason why the U.S. economy has outperformed the plodding European and Japanese economies is the timely, massive and unprecedented responses of U.S. policy makers in 2008-09. So let’s get the history right.”

Getting “history right” has been a CBB focal point From Day One. In last week’s media barrage, Dr. Bernanke repeatedly stated that fiscal policy had turned contractionary – (or at best neutral) suggesting that fiscal stringency was a key factor in the Fed sticking with ultra-loose policies. In Friday’s WSJ op-ed, Blinder and Zandi write, “Policy makers who botched the regulatory job before the crisis and shifted to fiscal restraint prematurely in 2011.”

Since the end of 2007, outstanding Treasury Securities (from Fed’s Z.1) have increased $8.302 TN, or 137%. As a percentage of GDP, outstanding Treasuries almost doubled to 83% (from 42%) in seven years. By calendar year, Treasury borrowings increased $1.302 TN (8.8% of GDP) in 2008, $1.506 TN (10.4%) in 2009, $1.645 TN (11.0%) in 2010, $1.138 TN (7.3%) in 2011, $1.181 TN (7.3%) in 2012, $858 billion (5.1%) in 2013 and $736 billion (4.2%) last year.

In nominal dollars, Federal expenditures increased from 2007’s $2.933 TN, to 2008’s $3.214 TN, 2009’s $3.487 TN, 2010’s $3.772 TN, 2011’s $3.818 TN, 2012’s $3.789 TN, 2013’s $3.782 TN and 2014’s $3.897 TN. Federal expenditures spiked during the crisis and remain about a third above 2007 levels.

“US Post Smallest Annual Budget Deficit since 2007” was a Thursday WSJ headline. “The deficit declined 9% from the prior year to $439 billion—around 2.5% of gross domestic product and below the average the U.S. has run over the past 40 years.”

I remember all too clearly the jubilation that surrounded federal budget surpluses in the late-nineties. Supposedly, a disciplined Washington had made tough choices and finally put its house in order. There was even talk of Treasury completely paying off its debts. It was, however, all a seductive Bubble Illusion. In particular, receipts were inflated by Credit excess-induced capital gains taxes (on inflating stock and asset prices) and booming incomes (especially tech and finance related!). Actually, it all seemed obvious even at the time. It didn’t make sense to me that the Fed and analysts were so prone to misinterpreting underlying dynamics.

Blinder and Zandi: “Yes, QE has possible negative side-effects, but for the most part they have yet to materialize.”

There are myriad deleterious side-effects, and anyone paying attention would agree that many have begun to materialize. One prominent consequences of Federal Reserve rate manipulation has been the loss of the markets’ ability to discipline policymaking. How does it ever make sense to allow politicians access to years of virtually free “money”? Ominously, despite Treasury paying basis point to service a large chunk of our outstanding debts, the federal government is still running significant deficits. While outstanding Treasury debt has increased almost 140% in seven years, 2014 interest payments were up only 8% from 2007 (to $440bn).

Government social payments, on the other hand, were up 48% from 2007 levels to $1.897 TN.

Slashing Treasury borrowing costs is not the only way the Fed has temporarily boosted the U.S. fiscal position. Funding a near $4.5 TN Fed balance sheet with virtually interest-free funding is (for now) a “money”-making endeavor. Last year the Fed remitted “profits” back to Treasury to the tune of almost $100 billion. Reflationary monetary policies have also been instrumental in resurgent Fannie Mae and Freddie Mac. A hiatus in loan losses allowed Fannie and Freddie to remit almost $140 billion in “profits” back to the Treasury (funds that should have remained as a capital buffer).

At this point, markets assume Treasury yields will not rise meaningfully in the foreseeable future. And, apparently, a deep recession remains out of the question. Yet Bubbles inevitably burst. Even a typical recession-induced slump in receipts and jump in spending would at this point see the almost immediate return of enormous federal deficits. Then ponder taking away Fed remittances to the Treasury and factor in another GSE bailout -and things deteriorate dramatically. A reasonable forecast would also incorporate a boost in defense spending. In a few short years federal debt would surpass GDP. Worse yet, at any time an unexpected surge in market yields would rather quickly endanger the balance sheets of the Treasury, the GSEs and the Federal Reserve – with nasty ramifications for the banking system, the economy and finance more generally.

Blinder and Zandi: “Logic dictates that the size of any stimulus be proportional to the expected decline in economic activity—which was enormous in the Great Recession.”

I am reminded of an invaluable “Austrian” insight (paraphrased): “The scope of the down cycle is proportional to the excesses of the preceding Credit boom.” From this perspective, there is major problem with conventional “logic.” These so-called “proportional” monetary and fiscal responses have over the past 25 years fueled serial Bubbles - and attendant progressively more dangerous Boom and Bust Dynamics. Especially when it comes to monetary policy, it was recognized a long time ago that the problem with giving central bankers too much discretion was that policy mistakes would invariably be followed by greater blunders.

It’s sad to see Capitalism under such attack in the national discourse. Washington seems only somewhat less despised than Wall Street. Somehow socialist ideas appeal to a growing number of Americans – especially the young. On this score, I’m content to be repetitive: Federal Reserve activism and inflationism bear primary responsibility.

In this week’s Democratic debate, Hillary Clinton stated, “Sometimes Capitalism must be saved from itself” and “It’s our job to rein in the excesses of capitalism so that it doesn’t run amok and doesn’t cause the kind of inequities that were seeing in our economic system.”

I’ll argue passionately the notion that politicians must save Capitalism from itself is the materialization of a dreadful “negative side-effect” of monetary mismanagement. If politicians are determined to get involved, they should foremost insist on sound money. Since politicians have throughout history demonstrated their proclivity for the exact opposite, Capitalism has been essentially entrusted to sound central bank principles. And while this may have not yet materialized to most, central banking has failed. It goes back to flawed doctrine where the Federal Reserve refused to address inflating Bubbles, preferring instead a policy of aggressive post-Bubble reflationary “mopping up.” It goes back to the Greenspan Fed’s tinkering with the markets to the Bernanke Fed’s crisis management QE to the Bernanke/Yellen/Kuroda/Draghi central bank non-crisis open-ended QE.

Regrettably, I fully expect to be defending Capitalism throughout the remainder of my life. I’ll try to explain how Capitalism isn’t – wasn’t – the problem. The culprit instead was unsound finance and deeply flawed monetary management. In short, Capitalism cannot function effectively within a backdrop of unfettered cheap finance. Things appear miraculous during the boom, and then the bust discombobulates.

Contemporary central bank rate administration essentially abandoned the self-adjusting and regulating market system of determining the price of finance – so fundamental to Capitalism.

The results have been predictable: gross misallocation of real and financial resources, economic stagnation, financial fragility, wealth redistribution, rising social and geopolitical tension and central bankers absolutely incapable of extricating themselves from inflationism and market manipulation.

I doubt there are too many traders or hedge fund operators these days that would argue against the Monetary Disorder Thesis. While the major indices appeared more quiescent this week, there remains plenty of instability below the surface. The week saw the broader market underperformed the S&P500. The Transports dropped 2%, while the Utilities gained 2%. The Biotechs were again notable for their inability to sustain a rally.

The Brazilian real reversed hard to the downside, dropping 4.3% this week. Brazilian stocks sank 3.5%. The Malaysian ringgit and Indonesian rupiah both declined about 1%. The squeeze in commodities markets gave way to selling. Crude sank 4.8%, as the Goldman Sachs Commodities Index fell 2.7%. Gold and Silver bucked the trend, with these long-term stores of value gaining 1.8% and 1.3%. Also quietly trading more positively, the yen gained 0.7% against the dollar this week, briefly trading back to August highs. Meanwhile, the VIX dropped to a near three-month low 15. Treasury yields dropped.

The thesis remains that the global Bubble has been pierced. In a world of open-ended QE, unprecedented policy activism and Trillions of trend-following and performance-chasing finance, there will be erratic ebb and flow to market activity – including EM. There were more announcements of hedge funds closing shop this week. For the industry overall, I doubt the recent market rally has relieved much pressure. Many funds were likely caught up in the powerful equities, EM and commodities short squeeze.

It seems apropos to note that shorting is not really the inverse of investing on the long side. The risk profiles are altogether different. On the long side, risk is limited. If an investor is right on the research and is willing to wait out market swings, risk is generally manageable. It’s another story on the short-side. Risk is unlimited. You can be right on the analysis but still loose money in a hurry if caught in the vortex of a powerful short squeeze dynamic.

This short squeeze dynamic has come to wield significant general market impact. With hedge fund and ETF industry assets each now at around $3.0 TN, the level of trend-following trading activity is unprecedented. In theory, one would expect such a backdrop to spur market overshooting both on the upside and down. Except that central bankers have repeatedly backstopped the markets to ensure that downside momentum does not gather pace.

In the past, the Fed and central banks used various backstop measures, including rate cuts, QE or simply talk of further policy loosening. Post-August “flash crash” market assurances have included the Fed delaying “lift off” and even chatter of negative rates. The ECB hinted at boosting QE. Chinese officials responded with a laundry list of stimulus and market controls.

By repeatedly intervening to arrest market downside momentum, the Fed and central banks nurtured a backdrop conducive to powerful short squeezes. The current exceptionally speculative marketplace plays right into this dynamic. After all, few (if any) market themes offer the quick trading profit opportunities as squeezing the shorts. And with the faltering global Bubble and elevated risk generally, short positions and bearish hedges had been mounting in recent months.

It’s worth recalling that Nasdaq went on its final speculative melt-up in early 2000, in the face of rapidly deteriorating industry fundamentals. Short squeezes and a dislocation in equities derivatives played prominently. And there were some decent squeezes and a collapse in the VIX just prior to the 2008 fiasco. Just because the market is within striking distance of record highs does not indicate that the downside of a historic Bubble period isn’t materializing. It would be much healthier if (self-adjusting) markets were capable of letting some air out gradually.