Doug Noland: Crazy Extremis

Dr. Bernanke has referred to the understanding of the forces behind the Great Depression as the “Holy Grail of Economics.” But was the Great Depression chiefly the consequence of post-crash policy mistakes, as conventional thinking has come profess? Was it really a case of the Federal Reserve having grossly failed in its responsibility to expand the money supply? Or did the previous “Roaring Twenties” Bubble sow the seeds of a major down-cycle and collapse?

Having in the past carefully read through Bernanke’s writings on the twenties and subsequent depression, it was clear his analysis had a fundamental flaw: it disregarded momentous market dynamics that unfolded following the creation of the Federal Reserve system and recovery following the first world war.

The unprecedented buildup of speculative leverage throughout the twenties boom played an instrumental role in systemic liquidity abundance that fueled both financial distortions and economic maladjustment. Confidence in the Federal Reserve’s capacity to sustain marketplace liquidity was instrumental in bolstering a progressively speculative market environment that culminated in the 1927 to 1929 speculative blow-off.

There are those who believe the Federal Reserve should have acted even more aggressively when subprime cracked in mid-2007. More aggressive stimulus measures (why not QE in 2007?) and a Lehman bailout would have averted the “worst financial crisis since the Great Depression.”

As the late Dr. Kurt Richebacher would often repeat, “the only cure for a Bubble is to not let it inflate.” Certainly, the longer Bubbles expand the greater the underlying fragilities – ensuring timid central bankers unwilling to risk reining in excess. This was the problem in the late-twenties and in 2006/2007. I would argue this has been a fundamental dilemma for central bankers persistently now for going on a decade. Especially after the Bernanke Fed targeted risk assets as the key reflationary mechanism, central banks have been loath to do anything that might risk upsetting the markets. Remember the 2011 “exit strategy” – promptly scrapped in favor of another doubling of the Fed’s balance sheet to $4.5 TN (by 2014).

From my analytical perspective, things have followed the worst-case scenario now for over three decades. Alan Greenspan’s assurances and loose monetary policy after the 1987 crash spurred “decade of greed” excesses that culminated with Bubbles in junk bonds, M&A and coastal real estate. The response to severe early-nineties bank impairment and recession was aggressive monetary stimulus and the active promotion of Wall Street finance (GSEs, MBS, ABS, derivatives, hedge funds, proprietary trading, etc.).

Once the boom in highly speculative market-based Credit took hold, there was no turning back. The 1994 bond bust ensured the Fed was done with the type of rate increases that might actually impinge speculation and tighten financial conditions. The Mexican bailout guaranteed fledgling Bubbles would run wild in Southeast Asia and elsewhere. The LTCM/Russia market “bailout” ensured Bubble Dynamics turned absolutely crazy in technology stocks and U.S. corporate Credit. Things took a turn for the worse following the “tech” Bubble collapse. With Wall Street cheering on, the Federal Reserve fatefully targeted mortgage Credit as the key mechanism for system reflation. A doubling of mortgage debt in just over six years was one of history’s more reckless monetary inflations. The panicked response to the collapsing mortgage finance Bubble fomented by far the greatest monetary inflation the world has ever experienced: China; EM; Japan; Treasury debt; central bank Credit; speculative leverage everywhere…

The “global government finance Bubble” saw egregious excess break out at the foundation of finance – central bank Credit and sovereign debt. It was a “slippery slope”; no turning back. The sordid history of inflationism has been replayed: once monetary inflation commences it becomes virtually impossible to stop. There was barely a pause in the ECB’s $2.6 TN QE program before the electronic “printing presses” were fired up again. The Fed’s balance sheet inflated from less than $1.0 TN pre-crisis to $4.5 TN. After contracting to $3.7 TN this past August, it’s now quickly back above $4.0 TN. The Bank of Japan hasn’t even attempted to rein in QE, with assets at a record $5.3 TN – up from the pre-crisis $1.0 TN.

Believing “THE” Bubble had burst in 2000, the Fed saw no basis for not aggressively “reflating.” The Fed and global central bankers were convinced “THE” Bubble collapsed in 2008. It would be reckless not to proceed with history’s greatest concerted monetary inflation. “Whatever it takes” was necessary to save the euro and European integration. Globally, the scourge of deflation has apparently been lurking around every corner – for a decade. It was imperative for the Bank of Japan to demonstrate absolute resolve.

Things got completely away from Beijing. Having studied the Japanese experience, they failed to grasp the necessity of quashing Bubble excess early. Over time, GDP targets, global power dynamics and the fear of bursting Bubbles took precedence. As it turned out, the greater their Bubble inflated the more heated the U.S./China rivalry. In theory, it seemed reasonable to let air out of the Bubble gently. In reality, powerful Bubbles only scoff. As conspicuous as debt excesses and economic maladjustment became, “structural reform” took a backseat to negotiations with Donald Trump. A key Credit Bubble adage comes to mind: There’s never a convenient time to deflate a Bubble.

My view is that Chinese financial and economic fragilities were a major contributor to this past year’s historic global yield collapse. Present a highly speculative marketplace a high probability of aggressive monetary stimulus and you’re asking for a destabilizing “blow-off.” And in this strange world in which we live, wild speculative Credit market excess (i.e. collapsing yields) is viewed by nervous central bankers as a signal to employ aggressive monetary stimulus.

November non-farm payrolls jumped 266,000, much stronger-than-expected and the largest job growth since January (41.3k returning GM workers). The jobless rate declined to 3.5% (matching low since 1969), as average hourly earnings gained 3.1% from November ’18. For a fourth consecutive month of gains, preliminary December University of Michigan Consumer Confidence jumped to (an above estimates) 99.2, the strongest reading since May (and only 2 pts from the strongest reading going back to 2004). At 115.2, the reading on Current Conditions (up 10 points since August) jumped to a one-year-high.

The Fed erred in cutting rates three times this year. It was arguably a crucial policy blunder, though in all likelihood the exact opposite will be argued in the future: The Fed should have stimulated more aggressively. We can anticipate the assertion the Fed flubbed last year in raising rates. Heck, the Federal Reserve should have gone full Japanese: zero rates and QE indefinitely. The S&P500 ended the week with a year-to-date gain of 25.5%, lagging Nasdaq’s 30.5%. The Nasdaq Computer Index has jumped 43.8%, with the Semiconductors (SOX) surging 49.3%. The Banks (BKX) have enjoyed 2019 gains of 29.3%.

Markets have virtually no concern the Fed might reassess its policy course and reverse rate cuts (what happened to “mid-cycle adjustment”?). Markets see only a 1.7% probability of a rate increase by the June 2020 FOMC meeting, while the probability of another cut sits at 42.9%. Curiously, the bond market took Friday’s robust economic data calmly. Ten-year Treasury yields rose only three bps Friday to 1.84% (up 6bps for the week). A delayed reaction wouldn’t be surprising. Perhaps bonds are holding out hope for negative trade headlines. But an asymmetrical Fed policy bias (no rate increase at least through next November’s elections) seems for now to work for both stocks and bonds.

It’s difficult to define “crazy”. I suppose you know it when you see it. It’s a central facet of Bubble Analysis that things get crazy at the end of cycles. Arguing that we’re in the throes of the history’s greatest global Bubble, we shouldn’t underestimate Craziness Extremis. Bear markets and recessions have been rescinded. Stocks always to up. Debt and deficits don’t matter. The Beijing meritocracy is up to any challenge. Global central bankers have things well under control.

I’ve been thinking a lot lately about a key unheeded lesson from the mortgage finance Bubble experience: prolonged market distortions come with grave consequences. The belief that the Fed and Treasury wouldn’t tolerate a housing crisis was instrumental in the mispricing of finance that saw yields drop (prices rise) in the face of a doubling of total mortgage debt. The perception of government-imposed safety abrogated the market pricing mechanism. Supply and demand no longer dictated the price of mortgage Credit. The market became unhinged.

Over the years, I’ve described how a Bubble in high-risk junk bonds would pose limited systemic risk. If things heated up – if issuance got out of hand, the market would howl, “No More Junk!” Market discipline would essentially bring the boom to a conclusion prior to prolonged excess and the onset of deep structural maladjustment.

A Bubble financed by “money” is perilous. There is, after all, essentially unlimited demand for instruments perceived as safe and liquid stores of (nominal) value. Implied federal guarantees of GSE debt and assurance of aggressive Federal Reserve reflationary measures in the event of instability bestowed the precious attribute of moneyness (“Moneyness of Credit”) to mortgage-related debt during that fateful Bubble period.

More than a decade ago I warned of the “Moneyness of Risk Assets” – with Bernanke’s reflationary measures having lavished the perception of safety and liquidity upon equities, corporate Credit and derivatives.

November 30 – Financial Times (Chris Flood): “Global assets held by exchange traded funds have climbed to a record $6tn, doubling in less than four years… The sector’s explosive growth has attracted heightened scrutiny by regulators who are concerned about the influence of ETFs as they spread deeper and wider into financial markets worldwide. ‘Passing the $6tn milestone is a historic moment but we are still in a relatively early stage of the industry’s development as ETF adoption rates across Europe and Asia are well below those seen in the US,’ said Deborah Fuhr, co-founder of ETFGI…”

And if the incredible flows into perceived safe and liquid ETF shares weren’t enough… Is this the time to run to – or away from – the bond market?

December 1 – Financial Times (Chris Flood): “Exchange traded funds linked to bond markets have attracted higher investor inflows than equivalent equity products this year in a highly unusual development in the history of the ETF industry. Bond ETFs have traditionally accounted for a fraction of the new cash entering the $5.9tn segment of the asset management world… But this pattern has reversed in 2019 for the first time. Investors have ploughed $191bn into fixed income ETFs in the first 10 months, compared with less than $158bn in new cash gathered by equity ETFs, according to ETFGI… ‘Adoption rates have accelerated noticeably as more investors have realised that fixed income ETFs can provide efficient solutions to some of the liquidity challenges of cash bond markets,’ said Deborah Fuhr, co-founder of ETFGI.”

The mortgage finance Bubble finally got into serious trouble when the “blow-off” subprime mania had driven home prices to unsustainable levels. Speculators turned cautious, financial conditions tightened, the marginal subprime buyer lost access to Credit, home prices reversed, the Bubble faltered, and the fringe of mortgage Credit lost its “moneyness.” Those highly levered in mortgage securities lost access to funding and crisis erupted. Market and economic structures having become addicted to Credit and liquidity excess were suddenly starved of both.

In a replay of the previous Bubble, government distortions have ensured a complete breakdown in market pricing mechanisms. Yields have declined (securities prices inflated) in the face of a tripling of Federal debt. And with central bank Credit and government debt fueling the Bubble, markets breathe easily. What could go wrong? There’s no subprime and home price dynamic that could bring the party to a bitter end. And as the Italian debt market has demonstrated, market concern for the quantity, quality and liquidity of sovereign debt can be alleviated through the expansion of central bank Credit (“money”).

So how might this all come to an end? Where is the current Bubble’s soft underbelly – the area of potentially acute fragility?

December 2 – Bloomberg (Yalman Onaran): “Flare-ups in the repo market could still cause worries across the global banking system, more than two months after chaos subsided in this vital corner of finance. Of particular concern: U.S. Treasuries, the world’s biggest bond market and the place where the federal government funds its escalating deficit. If repo rates become jumpy again — and many are girding for that to happen in the middle and end of this month — some of those leveraged investors may have to unwind Treasury holdings, potentially increasing the U.S. government’s interest costs at a time of record borrowing. ‘If repos were much harder to get at reasonable rates, Treasury prices would drop,’ said Darrell Duffie, a Stanford University finance professor who’s co-authored research on repo with Federal Reserve staffers. ‘The cost to taxpayers for funding the national debt would therefore rise.’”

Global securities funding markets could well prove a critical weak link. Over recent months, instability has erupted in China’s money markets. There have been indications of vulnerability in global dollar funding markets. And, of course, there were September’s “repo” market convulsions here at home.

The Bloomberg article noted above included the following: “As U.S. government debt rose by $1 trillion in the 12 months through March, more than 80% of it was absorbed by ‘other investors,’ a category in the U.S. Treasury Department’s latest available database that includes broker-dealers and hedge funds. In the same period, holdings by primary dealers… increased by only about $100 billion.” Another Bloomberg article (see “China Watch”) discussed China’s $4.7 TN market in local government financing vehicles (LGFV), much of this market offering relatively high interest rates. A third Bloomberg article (see “Leveraged Speculation Watch”) noted “China’s crowded market of close to 9,000 hedge funds.” These are serious problems.

Evidence and anecdotes continue to support the thesis of unprecedented global leverage having accumulated throughout this most protracted boom cycle. People’s Bank of China liquidity injections stabilized China’s money market. Federal Reserve Credit expanded $293 billion in 12 weeks, pacifying U.S. overnight “repo” funding markets. But there’s a major problem: distorted markets and central bank backstops have afforded blank checkbooks to governments around the world. The U.S. Treasury is poised to run Trillion dollar deficits for as far as the eye can see. And so long as markets are fearing trade wars, recession and deflation, downward pressure on bond yields keeps the game chugging along.

Yet the possibility of a trade agreement, economic expansion and some inflationary pressures could prove problematic. Rising bond yields would put pressure on highly leveraged and vulnerable markets. In all the discussion of “repo” market issues and challenges, the key point is somehow missed: Accommodating and promoting a market that finances speculative leveraging virtually guarantees problematic Bubbles. How could this lesson not have been learned in 2008? Now it’s a global Bubble, with all the issues of financial fragility, economic maladjustment, and wealth redistribution on an unprecedented scale.

Original Post 7 December 2019


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Categories: Doug Noland, Perspectives