Doug Noland: Arms Race

Bloomberg: “Treasuries Surge as December Hike Odds Drop After CPI Miss.” Year-over-year CPI was up 2.2% in September, with consumer inflation above 2% y-o-y for six of the past 10 months. The Producer Price Index gained 2.6% y-o-y in September. Yet, apparently, the focus will remain on core CPI (along with core personal consumption expenditure inflation) that, up 1.7% y-o-y, missed estimates by one tenth and remained below 2% for the sixth straight month. Notably – analytically if not in the markets – the preliminary October reading of University of Michigan Consumer Confidence jumped six points to the high since January 2004. Or taking a slightly different view, Consumer Confidence has been stronger for only one month in the past 17 years. Current Conditions rose to the highest level since November 2000.

Data notwithstanding, from Bloomberg: “Bond Shorts Experience the Agony of Defeat Yet Again.” Ten-year Treasury yields declined nine bps this week to 2.27%, though I’m not sure this qualifies as “defeat.” In stark contrast to the fanatical gathering on the opposing side of the field, not a single central banker was spotted on the bond bears’ sideline.

October 12 – Financial Times (Sam Fleming): “Worries about the risk of stubbornly low inflation hung over the Federal Reserve’s most recent policy meeting, even as the central bank held its course for a further rate rise as soon as the end of the year. Many of the US central bank’s policymakers declared at its latest rate-setting meeting that a further increase is likely to be needed ‘later this year’ as long as the economy stays on track. But minutes of the Fed’s gathering on September 19-20 revealed a body of policymakers who are troubled by this year’s doggedly weak inflation readings and divided over how best to respond. Many expressed worries that poor price growth could reflect entrenched factors following a half-decade of sub-target readings on the Fed’s favoured measure of core inflation. Several insisted they wanted to see economic data that ‘increased their confidence’ that inflation would move towards the Fed’s 2% objective before they acted again.”

October 13 – Reuters (Balazs Koranyi): “European Central Bank policymakers are homing in on extending their stimulus programme for nine months at their next meeting while scaling it back, five people with direct knowledge of discussions told Reuters. The ECB’s asset purchases are due to expire at the end of the year, and policymakers are set to decide on Oct. 26 whether to prolong them. They will have to reconcile the bloc’s best growth run in a decade with an inflation rate expected to undershoot the bank’s target of almost 2% for years. The next move is still up for discussion, but there is a consensus that it should signal both the need to cut support in light of strong economic growth, while also committing to an extended period of monetary accommodation…”

October 13 – Reuters (Leika Kihara): “Bank of Japan Governor Haruhiko Kuroda on Thursday stressed the central bank’s resolve to maintain its ultra-loose monetary policy, even as its U.S. and European counterparts begin to dial back their massive, crisis-mode monetary stimulus. Kuroda offered an upbeat view of Japan’s economy, saying it was expanding moderately with rising incomes leading to higher corporate and household spending. But he said inflation and wage growth were disappointingly low, despite such improvements in the economy.”

Goldman Sachs reduced its probability of a December Fed rate hike to 75%, as dovish comments from Fed officials and dovish minutes from the September FOMC meeting allay concerns that the Fed was leaning “normalization.” So global markets take comfort that the Fed is largely on hold with rate hikes; a rate increase may be at least a year away in the euro zone as the ECB sticks to its max leisurely path to winding down QE; and, best yet, the Bank of Japan is gratified to wait and see how the others get along without aggressive stimulus before contemplating its own course.

The S&P500 gained 0.2% this week to new record highs, increasing y-t-d gains to 14%. Indicative of the froth that has taken hold throughout EM, bastions of stability South Korea (up 22% y-t-d) and Turkey (up 36%) gained 3.3% and 2.0%, respectively. Meanwhile, Bitcoin (U.S. spot) surged $1,275 this week (29%!) to $5,615, with 2017 gains of a cool 480%. If central bankers have any concern with acute asset price inflation and speculation it was not apparent this week. And, sure enough, no sooner than Fed officials reiterate below-target inflation angst the commodities pop. The GSCI Commodities index jumped 2.8% this week to a six-month high. Copper rose 2.8% this week, increasing y-t-d gains to 25%. Crude jumped 4.4%, silver 3.7% and Gold 2.2%.

Markets these days have attained that late-nineties feel. Manic 1999 had those crazy Internet stocks. Manic 2017 has the even crazier cryptocurrencies – with biotech (up 39% y-t-d) and semiconductor (up 35%) stocks straining to keep up with the insanity. In the face of conspicuous speculative excess, the Fed in 1999 held firm with its baby-step “tightening” approach that worked only to promote a further loosening of financial conditions. The 1998 crisis was fresh in central bankers’ minds, while markets delighted in the fear central bankers harbored over Y2K. As for central banks here in 2017, apparently the 2008 crisis will remain forever top of mind. Markets have never been as reassured that central bankers are loving the party.

By 1999, a policy-induced prolonged technology boom had fostered a veritable Arms Race, especially in anything Internet and PC. Finance was flooding into the sector, ensuring massive mal- and over-investment. The upshot was the rapid propagation of negative cash-flow enterprises that would turn unviable the minute the Bubble burst. The New Age hype had one thing right: Exciting new technologies changed the world. This did not, however, prevent painful busts and a pair of powerful financial crises.

There’s complacency along with a lack of appreciation for the long-term structural impact associated with late-nineties excesses. I continue to read of the “mild recession” after the bursting of the “tech” Bubble. In reality, collapse ensured depression throughout a segment of the economy. And let’s not forget the 2002 corporate debt crisis.

The Fed held powerful reflationary tools at its discretion. Rates were slashed from 6.5% in December 2000 all the way to 1.00% by June 2003. There was also a strong inflationary bias throughout mortgage finance and housing. This provided the Federal Reserve a robust avenue in which to promote record Credit growth and an attendant Bubble of sufficient scope to more than emerge from the technology bust. No nineties boom and bust then no mortgage finance Bubble reflation and resulting 2008 collapse – and no ongoing global government finance Bubble. Open the central bank crisis-fighting tool kit today and there’s a single slot for QE. Markets are elated with the virtually barren apparatus.

The current “tech” Bubble absolutely dwarfs the late-nineties period. Arms Races now proliferate across various industries, technologies and products on a global basis. Recalling 1999, media these days are filled with ads from scores of upstarts promoting new products and services. How many will ever generate positive cash-flow and earnings? The big global tech firms – flush with extraordinary boom-time profits – spend lavishly in an Arms Race for primacy over the cloud, artificial intelligence and myriad new services. Alternative energies, another Arms Race. Media, telecom, entertainment and programming – more Arms Races. Pharmaceuticals, biotech and biopharma…

And then there’s the massive Arms Race gathering momentum in electric vehicles. “British Vacuum Maker Dyson Plans Electric Car Assault” – with, it’s worth noting, a $2.0 billion investment. From the Seattle Times, “In Race for an Electric-Car Future, China Seeks the Lead.” With a blank checkbook and the power to ban the combustion engine, China will invest hundreds of billions in electric car and battery development. Will anyone ever earn a profit?

One can do worse than ponder the work of the great economist Joseph Schumpeter. Known most for the concept “creative destruction,” Schumpeter was an eminent thinker on economic development and Credit. He believed innovation often evolves in “swarm like clusters,” where development in one sector spurs innovation and development in other areas. Entrepreneur success in one field motivates entrepreneurship more generally. Moreover, innovation fuels – and is fueled by – Credit. The interplay of the entrepreneur and finance plays a fundamental role in boom and bust cycles. Eventually over-production, waning profits and Credit issues lead to cyclical downturn.

Schumpeter’s analysis would occasionally enter the discussion back in the late-nineties. Some of us would compare the proliferation of new technologies to that of the “Roaring Twenties” period (automotive, production line, electricity, radio & entertainment, refrigeration, household appliances, science & medicine, etc.). There’s no doubt that innovation and speculation tend to become kindred spirits.

The Greenspan Fed, Wall Street strategists and most economists argued during the nineties that new technologies had raised the economy’s “speed limit.” This meant less impetus to tap on the monetary brakes to subdue the boom. I saw things differently: Periods of breakneck innovation, technological advancement and resulting economic transformation beckon for a commitment to sound “money.” Especially in our age of unbounded market-based finance, captivating innovation in the real economy over time spurs precarious self-reinforcing excess in “money,” Credit, the securities markets and derivatives.

It’s my view that prolonged cycles of economic and financial innovation turn progressively more perilous. The key analysis from the “Roaring Twenties” period was one of spectacular economic and financial innovation commencing even before the outbreak of the first World War. As the Twenties progressed, our fledgling central bank misread the downward pressure on consumer prices. Technological advances, new production methods, a proliferation of new products, and booming international trade – all empowered by loose finance – were generating downward pressure on prices.

The Fed accommodated escalating financial excess and was later unwilling to risk bursting the Bubble (in the face of mounting late-cycle fragilities). At the heart of financial and economic excess was the prevailing view that the Federal Reserve possessed the tools to underpin uninterrupted financial and economic prosperity. The perception of adept central banking had become integral to a transformative change in inflation dynamics – massive investment spurring disinflation in the real economy in the face of powerful inflation dynamics raging in asset markets. What was viewed as an extraordinarily favorable fundamental backdrop was in reality an unsustainable boom, with an acutely unsound financial Bubble at its core. The many parallels to today are too obvious to ignore.

October 12 – ANSA: “European Central Bank President Mario Draghi defended quantitative easing at a conference with former Fed chief Ben Bernanke, saying the policy had helped create seven million jobs in four years. Bernanke chided the idea that QE distorted the markets, saying ‘It’s not clear what that means’.”

October 11 – Financial Times (Chris Giles): “Central bankers usurped the titans of Wall Street as the masters of the universe almost a decade ago. They rescued the global economy from the financial crisis, flooding the world with cheap money. They used their powers effectively to get banks lending again. Their actions raised asset prices, keeping business and consumer confidence up. Financial markets and populations hang on their words. But never have they been so vulnerable. As they gather in Washington for the annual meetings of the International Monetary Fund, there is a crisis of confidence in central banking. Their economic models are failing and there are doubts whether they understand the effects of interest rates and other monetary policies on the economy. In short, the new masters of the universe might not understand what makes a modern economy tick and their well-intentioned actions could prove harmful. While there have long been critics of the power of central bankers on the left and the right, such profound doubts have never been so present within their narrow world.”


Original Post 15 October 2017

Categories: Doug Noland, Perspectives