Doug Noland: Generational Turning Point?

There is an overarching issue I haven’t been able to get off my mind: Are we at the beginning of something new or in the waning days of the previous multi-decade cycle?

May 5 – Wall Street Journal (James Mackintosh): “We could be at a generational turning point for finance. Politics, economics, international relations, demography and labor are all shifting to supporting inflation. After more than 40 years of policies that gave priority to the fight against rising prices, investor- and consumer-friendly solutions are becoming less fashionable, not only in the U.S. but in much of the world. Investors are woefully unprepared for such a shift, perhaps because such historic turning points have proven remarkably hard to spot. This may be another false alarm, and it will take many years to play out, but the evidence for a general shift is strong across five fronts.”

The “five fronts” underscored in Mr. Mackintosh’s insightful piece are as follows: 1) “Central banks, led by the Federal Reserve, are now less concerned about inflation.” 2) “Politics has shifted to spend even more now, pay even less later.” 3) “Globalization is out of fashion.” 4) “Demographics worsen the situation.” 5) “Empowered labor puts upward pressure on wages and prices.”

The analysis is well-founded, as is the article’s headline: “Everything Screams Inflation.” After surging another 3.7% this week (lumber up 12%, copper 6%, corn 9%), the Bloomberg Commodities Index has already gained 20% this year. Lumber enjoys a y-t-d gain of 93% – WTI Crude 34%, Gasoline 51%, Copper 35%, Aluminum 26%, Steel Rebar 32%, Corn 51%, Soybeans 22%, Wheat 19%, Coffee 18%, Sugar 13%, Cotton 15%, Lean Hogs 59%… The focus on inflation is clearly justified. Yet Mackintosh began his article suggesting a “Generational Turning Point for finance” – rather than inflation. Let’s explore…

I mark the mid-eighties as the beginning of the current super-cycle. A major collapse in market yields (following the reversal of Paul Volcker’s tightening cycle) promoted financial innovation and the expansion of non-bank Credit expansion. Markets were turning increasingly speculative, while the economic boom was spurring increasingly destabilizing trade and Current Account Deficits. These deficits were helping feed Japan’s Bubble, fueled both by international financial flows as well as the misguided Japanese policy response seeking to use monetary stimulus to boost U.S. goods imports and rectify its ballooning trade surpluses. In the U.S., increasingly acute Monetary Disorder led to the “Black Monday” – October 19th, 1987 stock market crash.

The Greenspan Fed’s crash response launched a regime of activist central bank measures specifically directed at supporting the securities markets. U.S. stocks swiftly recovered, while loose financial conditions stealthily promoted the evolution of non-bank finance. Post-crash Bubble reflation developments cemented the “decade of greed” moniker. Michael Milken and the proliferation of junk bonds and leveraged finance. Insider trading, Ivan Boesky, the LBO boom, Charles Keating, and the Savings & Loan (S&L) fiasco. And, importantly, post-crash reflationary measures pushed Japan’s Bubble to catastrophic “Terminal Phase Excess.” After ending 1987 at 21,564, the Nikkei Index traded to an all-time high 38,916 on the final trading session in 1989.

All kinds of things went wrong in 1990 – including war and recession. Late-eighties U.S. bubbles burst in unison, including coastal real estate, junk bonds, LBOs, and the S&Ls. Japan’s Bubble began to unravel. Collapsing Bubbles left the U.S. banking system badly impaired, with multiple major failures and even concerns for the solvency of Citicorp. Already huge fiscal deficits were at risk of exploding uncontrollably, due to ballooning costs of bank and S&L recapitalizations.

“The Maestro” pushed central bank activism to a whole new level, collapsing rates and manipulating the yield curve. Banks were encouraged to borrow short (cheap) and lend long (dear), pocketing easy spread profits while rebuilding capital. Finance, financial structure and policymaking were changed forever. Importantly, Greenspan’s policies were a godsend to the fledgling leveraged speculating community that prospered on hugely profitable “carry trades” and levered derivatives strategies – and never looked back.

When the bond/derivatives Bubble burst in 1994, the rapidly expanding GSEs were elevated to quasi-central banks. The GSEs began aggressively buying debt securities during periods of market instability, creating a liquidity backstop that fundamentally altered the risk vs. reward dynamics of leveraged speculation and derivatives strategies more generally. With their implicit government debt guarantees, the GSEs enjoyed unlimited access to cheap market-based borrowings. Meanwhile, the Mexican bailout and global policy responses (including from the IMF) to a series of devastating EM Bubble collapses (SE Asian “Tigers” to Russia) reinforced the market perception that central banks, governments and inter-governmental agencies were all now fully committed to backstopping the rise of market-based “Wall Street finance”.

The 1998 LTCM bailout – and post-crisis GSE/Fed reflation measures – pushed the U.S. “tech” Bubble in 1999 to dangerous “Terminal Phase Excess.” The Fed’s post-tech Bubble reflationary measures then stoked the more expansive and systemic “mortgage finance Bubble”. And yet another post-Bubble reflation stoked this super-cycle’s “Terminal Phase” “global government finance Bubble.”

The pandemic erupted at a critical Bubble juncture. Speculative excess had already turned problematic. Financial and economic fragilities were manifesting globally, particularly in Bubble heavyweights U.S. and Chinese financial systems. In the summer of 2019, China was facing instability at its Credit system’s “periphery”, notably within the giant “small banking” sector. In the U.S., the eruption of repo market (a key source of finance for leveraged speculation) instability provoked the latest iteration of activist/inflationist monetary management – the so-called “insurance” monetary stimulus.

The Fed redeployed QE in the face of highly speculative markets (stocks near records) and unemployment at multi-decade lows. Arguably, this stimulus and resulting Bubble excess contributed to latent fragilities that erupted in near market collapse in March 2020. The Fed’s balance sheet has more than doubled (108%) in 86 weeks to $7.81 TN. A full-fledged mania erupted – stocks, cryptocurrencies, corporate Credit, SPACs, derivatives, houses, etc. Washington ran a $4.8 TN, or almost 25% of GDP, deficit in only 18 months.

Considering the unprecedented nature of recent excess, there is today every reason to contemplate a secular shift in inflation dynamics. The Fed is locked into runaway monetary inflation, while its new inflation-targeting regime specifically seeks to promote above-target inflation. Moreover, Washington had grown comfortable with massive deficits even prior to covid. Now, the Biden administration is pushing gargantuan spending programs, in what is a predictable political response to flagrant inequality and derelict infrastructure. There is also the astronomical cost of adjusting to climate change. Mr. Mackintosh’s above article highlights the major factors supporting the secular inflation thesis.

But what about finance? Central bank policies now command market trading dynamics, while government-related debt dominates system Credit expansion. There is every reason to believe state-directed lending, after reaching new extremes during the pandemic, will become only more obtrusive going forward. A compelling case can be made this new age of government directed finance and spending is now driving a new inflationary cycle.

However, I certainly don’t want to dismiss end-of-cycle dynamics. “Blow-off” dynamics, after all, are proliferating. One can start with the trajectory of the Fed’s balance sheet, along with unbounded fiscal deficit spending. There are, as well, myriad indications of “Terminal Phase” speculative excess, including numerous manias, over-leverage, ETF flows, corporate bond issuance, the Ark funds, etc. The breadth and scope of such extreme behavior portend change is in the offing.

These days, markets and about everyone anticipates that historic monetary and fiscal stimulus will continue to fuel historic asset bull markets. The existing cycle is very much intact, it is believed, with New Age central banking continuing to underpin unrestrained fiscal spending. But could both monetary and fiscal authorities have pushed things too far? Could we be nearing a major adjustment, where the respective interests of an expansive government and the markets finally diverge? Might a bout of market discipline catch Washington, along with about everybody, by complete surprise? A crazy thought.

This history of monetary inflation informs us that once it begins in earnest, it becomes extremely difficult to rein in. After expanding assets by $4.0 TN in about 18 months – and stoking historic manias in the process – any Fed retreat in the direction of “normalization” will prove highly destabilizing (a dynamic clearly not lost on Fed officials). A similar dilemma holds true for the Federal government after it’s $4.8 TN deficit spending free-for-all. Meanwhile, “melt-up” speculative market dynamics are similarly problematic. There is no reason to expect the type of historic excess we’ve been witnessing to end with a whimper.

All the key dynamics shaping finance have been pushed to such egregious “Terminal Phase” extremes. Shouldn’t we today be contemplating how such end-of-cycle dynamics might play out? A harsh market reaction to reckless Washington policymaking would appear long overdue. The flow of magma to the surface has been restricted for far too long. Could an inflation scare prove the catalyst for a market eruption?

Credit has been expanding rapidly throughout this most-protracted cycle. There has been tremendous debasement, yet for various reasons consumer price inflation remained relatively contained. Liquidity flowed into the securities and asset markets, while bond yields collapsed despite a historic increase in supply/issuance. Markets have been more than happy to accommodate huge fiscal spending and the attendant supply of government bonds. Of course it’s easy to extrapolate this wondrous dynamic far into the future.

But the markets’ failure to impose discipline had predictable consequences. Governments succumbed to late-cycle massive over-issuance, pushing the limits of market accommodation while also stoking general inflationary pressures. To this point, however, the Fed’s ongoing massive QE buying has masked deepening fragility. This has only emboldened deficit spending proponents, while throwing more fuel on both speculative manias and mounting pricing pressures throughout the real economy.

It all points to a major shakeout. An inflation upside surprise could come with momentous ramifications. The bond market would face major instability. Beyond debasement, there would be fear of a destabilizing de-risking/deleveraging dynamic taking hold. And market instability and illiquidity become even greater issues at the point when inflationary pressures weaken the Fed’s propensity for quick QE liquidity injections. Suddenly, the marketplace would be forced to reassess the reliability of its coveted liquidity backstop.

There’s a scenario we need to contemplate: Mounting inflationary pressures spook the bond market concurrent with the Fed moving forward its plans to wind down QE and commence rate increases. Bond market instability unleashes a bout of de-risking/deleveraging, a particularly problematic development for a highly levered corporate bond complex, as well as quite speculative equities markets. In such a scenario, the Fed would be under intense pressure to employ large QE purchases to underpin marketplace liquidity. A failure to act would be highly destabilizing for the markets. At the same time, another huge bout of QE in a backdrop of heightened inflationary concerns might prove problematic for bond investors.

It is worth recalling the chaos that ensued early in the March 2020 pandemic policy response. Markets continued a panicky de-risking/deleverage even as the Fed announced major liquidity operations. It was not until the Fed ratcheted up the response to monumental liquidity injections that crash dynamics were reversed. But speculation and leverage have surely expanded significantly over the past year, raising the issue of the scope of the next QE bailout necessary to again hold Bubble collapse at bay.

I believe another massive QE bailout program is inevitable. And such a program in the face of rapidly building inflationary pressures would risk a bond market backlash. This could throw Fed monetary doctrine into disarray: does it inflate its balance sheet to provide liquidity support to the markets, or must it focus instead on reining in inflationary policy measures to stabilize unsettled bond markets? A crisis of confidence in Federal Reserve policymaking would be a distinct possibility. And such a scenario would risk ending the past three decades’ nexus between progressively activist monetary management and ever-expanding financial Bubbles.

Markets have enjoyed reliable liquidity backstops going back to the GSEs in the mid-nineties. When accounting irregularities eventually ended Fannie and Freddie’s open-ended growth, the Fed’s balance sheet took over liquidity backstop operations. There are much different financial and economic worlds without a reliable Fed/central bank market liquidity backstop.

And while the assertion the Fed will always be there to backstop the markets has some merit, there are major challenges developing. Previous QE programs essentially directed liquidity into the markets. U.S. investment booms were for the most part disinflationary, with spending on new technologies, services, and digitized output creating an endless supply of “output” devoid of traditional upward pricing pressures.

Going forward, the investment boom will shift to infrastructure, along with a domestic manufacturing push. Climate change will require enormous investment in physical capital stock and associated manufacturing capacity. A strong case can be made this changing investment dynamic will play a significant role in evolving inflation dynamics. There will be tremendous demand for various commodities as well as skilled labor. Moreover, this will be a global phenomenon.

There were inflation concerns when the Fed initially employed QE in 2008. But that was in a post-Bubble backdrop replete with powerful real economy disinflationary forces. The liquidity and resulting inflationary effects remained largely contained within the securities markets. The “QE2” near doubling of the Fed’s balance sheet between 2011 and 2014 injected liquidity into a system with ongoing real economy disinflationary pressures, but with increasingly powerful inflationary Bubble Dynamics in the securities markets – at home and abroad. Market Bubbles, furthermore, fueled an investment boom throughout the expansive technology sector with minimal inflationary impacts upon the broader economy. Actually, the massive increase in supply of myriad technology gadgets, services and digitalized downloads acted as a sponge absorbing what would have traditionally been inflationary spending power.

There is already evidence the latest round of QE is fueling divergent inflationary dynamics. For one, it’s at such greater scope. Secondly, it has unfolded concurrently with unprecedented fiscal spending. Thirdly, QE was employed in an environment of already heightened real economy inflationary pressures – i.e. labor, housing, commodities, physical investment beyond new technologies, etc. And, finally, massive monetary stimulus comes following decades of inflationary dynamics that profoundly benefited securities prices and the wealthy at the expense of the working class. The inevitable social and political backlash, further energized by covid-related inequities, has spurred a flurry of wealth redistribution policy initiatives.

There is indeed every reason to contemplate the possibility of a momentous secular shift in inflation dynamics. This doesn’t necessarily mean CPI begins rising dramatically, although the likelihood of such an outcome is rising. But the strongest inflationary biases are poised to shift from the securities markets back to more traditional real economy impacts. This implies the Fed going forward will face obstacles in its “whatever it takes” open-ended QE doctrine. Rising inflation and a fragile bond market will force it to contemplate the risk of additional QE, while QE liquidity will now gravitate more toward inflationary dynamics within the real economy. This dynamic is already observable in booming commodities markets.

But back to the original question: Are we witnessing the start of something new – or the previous cycle’s end-game? There’s an understandable focus on how central banks and governments have hijacked Credit systems. To this point, this “money” has created an extraordinarily stable dynamic relative to runaway monetary inflation and debt growth.

Though bastardized by government intrusion, Credit remains dominated by market-based finance. Is this cycle of market-based Credit underpinned by activist central bank management sustainable? Or has the massive expansion of non-productive Credit, egregious monetary inflation, manic market excess and associated inflationary pressures created fragilities that place the existing financial structure at risk?

The Fed is in no hurry to find out. QE to the tune of $120 billion a month masks fragilities, while holding market adjustment at bay. And the mania rages on, while Washington luxuriates in blank checkbook overindulgence. Inflationary pressures mount. It’s worth noting the Dollar Index dropped 1.1% this week and is now only a couple percent from 2018 lows.

The future could not be murkier. Everyone is prepared for unchecked monetary and fiscal stimulus as far as the eye can see. But is existing market structure sustainable in a backdrop of unrelenting non-productive debt growth, rising inflation, waning central bank flexibility and shifting political priorities? A Bloomberg headline from Friday evening: “Reflation, Inflation, Deflation: Stocks Can Live With Everything.” I’m not convinced the financial Bubble can live without QE. Is massive monetary inflation the only thing sustaining a multi-decade market cycle?

Original Post 8 May 2021

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Categories: Perspectives