THINGS HAVE GONE TOO FAR / PRUDENTBEAR.COM

Things Have Gone Too Far

April 12, 2013

by Doug Noland


It seems a case of too much liquidity for too long having chased a limited amount of global risk assets. Instability.

“The Fed has been talking about asset bubbles since the ‘irrational exuberance’ speech which was 1996. So it’s nothing new. We had a big bubble in the nineties. A big bubble in the two thousands. Those two bubbles ended very differently. The Fed’s been talking, talking, talking about this. So it’s certainly been a concern. It is a concern today. But it’s like nothing new. This has been going on for 20 years. Frankly, there aren’t good answers because we don’t have great models of financial instability.” Federal Reserve Bank of St. Louis President James Bullard (February 21, 2013, in reference to a question on Fed governor Jeremy Stein’s paper)

The Fed’s been talking, while I’ve been doing my best to study bubble and Credit dynamics. I know we’ve again reached the stage of the cycle where those warning of Bubble risks have been discredited. This type of analysis tends to be humbling, a dynamic I became comfortable with some years ago. And at risk of sounding arrogant, I am comfortable stating that Federal Reserve officials remain for the most part dangerously uniformed when it comes to Credit, speculative market dynamics and Bubbles. At the heart of the problem, the Fed lacks an analytical framework for understanding the causes and consequences of financial instability. And especially with how global markets have been behaving, these issues deserve keen ongoing focus.

As difficult as it may be for most to believe, the world’s preeminent central bankers are a select group of highly intelligent public servants that suffer from a huge void in their understanding of contemporary finance. And the issue goes much beyond the lack of “great models of financial instability.” They subscribe to an erroneous and outdated doctrine of how finance operates and seem to share a flawed perspective with respect to the interplay of contemporary finance, financial markets and economies. Worse yet, Dr. Bernanke is wedded to a (Milton) “Friedmanite” revisionists view that the “Roaring Twenties” was the “Golden Age of Capitalism” brought needlessly to an end by negligent central bankers unwilling to print and inflate. His fixation has been with policy mistakes in the 1930s – with little apparent interest in those from the 20s, 70s, 80s, 90s or 2000s.

To be sure, finance fundamentally changed during the ‘90s. And while this trend had been in play for some time, the explosion of market-based finance took the world by storm throughout the 1990s with the huge growth in securitizations, the GSEs, derivatives, “repos,” “Wall Street finance”, and the hedge funds. Importantly, the Greenspan Fed moved to a market-friendly regime with transparent pre-commitments to pegged short-term interest-rates, market liquidity backstop assurances, and asymmetrical policy responses.

The impaired banking system (from late-80’s excess) certainly was an important factor in the “activist” Fed incentivizing non-bank Credit growth early in the decade. The deregulation wave played an integral role. Surging stock prices and attendant Notions of New Eras and New Paradigms created a backdrop supportive of financial and policy experimentation. There was, as well, Washington’s use of the ballooning GSEs to promote economic, social and political agendas.

The upshot was an unprecedented explosion of market-based Credit, much of it directed toward the asset markets. A complacent Federal Reserve failed to recognize the profound changes in finance until it was too late. The S&P500 returned 423% during the nineties, and by the end of the decade a full-fledged mania had taken hold in Nasdaq and tech stocks. There was by that point, apparently, no turning back. The world had entered An Era of Mispriced Finance.

Far too little analytical attention is paid to nineties’ novelties and transgressions. The 2008 collapse of the mortgage financial Bubble highlighted huge policy blunders, but the seeds for that (and future) crisis were planted in the previous decade’s financial and policy transformations. Federal Reserve policy had become integral to a dangerous regime of over-expanding mispriced finance, asset inflation and Bubbles.

Dr. Bernanke was brought in as the preeminent academic authority in deflations and post-Bubble “mopping up” reflationary measures. He didn’t for a moment consider adjusting for previous policy and market shortcomings – nor dare to move policy back in the direction of sounder and time-tested doctrine. The pricing or mispricing of finance was of no concern; he was just determined to have much more of it.

The Bernanke Federal Reserve became a laboratory for testing radical academic theories. Rather than recognize the clear risks of aggressive central bank financial system and market interventions, the Fed became the biggest inflator of asset Bubbles the world has ever known. They remain hard at work, steadfast and uncompromising in the face of conspicuous shortcomings and potential catastrophic failure. And, ironically, the greater the global dominance by inflated securities markets, the further the shift of central banking governance to academics with little experience or practical understanding of the functioning of contemporary market-based finance.

The enterprising Greenspan Fed committed monumental errors. It monkeyed too much with system mechanisms for pricing finance and risk - and it monkeyed too much with the financial markets. Fed policies were pro-Credit, pro-aggressive risk intermediation, pro-risk distortions, pro-asset inflation and pro-Bubbles. Greenspan’s policies incentivized leveraged speculation, an explosion of non-productive debt growth and problematic resource misallocation. The Bernanke Fed became only more pro-asset inflation, pro-government debt and pro-Bubbles, moving to only further incentivize speculation in securities markets around the world.

The Greenspan Fed ensured speculators predictable low-cost funding that was used to leverage MBS and higher-yielding Credit instruments. This ensured unlimited cheap borrowings for home (and other asset) purchases. The Bernanke Fed pre-commits to years of near zero cost finance for leveraged speculation, while monetizing Trillions of debt and MBS. The Greenspan equity market “put” was expanded to include Treasuries, MBS, muni debt, junk, student loans, etc. Bernanke significantly compounded Greenspan’s monumental errors.

Financial markets came to play an increasingly dominant role throughout the nineties. Leveraged speculation evolved to an all encompassing role in debt, equities and commodities markets. This should have been clear after the 1998 LTCM fiasco - and was made obvious with fragilities that manifested during the 2000-2002 bursting of the “technology” and corporate debt Bubbles. Serious errors didn’t so much as slow the move away from traditional central bank doctrine and policymaking. That Bernanke’s (“mopping up” and “printing”) reflationary doctrine only exacerbated myriad costs associated with mispriced finance and asset markets’ dominance was made abundantly clear in 2008/09.

So, we’re now in the fifth year of the Bernanke Fed’s experimental effort to directly inflate asset markets. Somehow, policymakers, economists and market pundits still argue that low CPI inflation affords global central bankers unusual flexibility to implement aggressive money printing operations. This completely ignores what should be, at this point, rather conspicuous asset Bubble risks.

Market commentators and the media are these days in a nineties-like fixation with record U.S. stock prices. Meanwhile, global markets show ongoing signs of heightened instability. Two-year German yields ended the week at one basis point, with 10-year yields not too far off record lows at 1.26%. The emerging markets continue to trade unimpressively. Key commodities, meanwhile, trade like death. The CRB Commodities Index closed Friday at the lowest level since last July. Friday saw crude hit for $2.22, gasoline 3.3%, copper 2.7%, palladium 3.3%, platinum 2.6%, aluminum 2.5%, nickel 2.6% and tin 3.7%. And the precious metals made the industrial metals look precious. Gold was hammered for $78 on Friday and $98 for the week, while silver was hit for 4.9% and 3.3%. The HUI Gold index now sports a 2013 decline of 32.2%.

With global central bankers “printing” desperately, the collapse in gold stocks and sinking commodities prices were not supposed to happen. Is it evidence of imminent deflation? How could that be, with the Fed and Bank of Japan combining for about $170bn of monthly “money printing.” Are they not doing enough? How is deflation possible with China’s “total social financing” expanding an incredible $1 Trillion during the first quarter? How is deflation a serious risk in the face of ultra-loose financial conditions in the U.S. and basically near-free “money” available round the globe?

Well, deflation is not really the issue. Instead, so-called “deflation” can be viewed as the typical consequence of bursting asset and Credit Bubbles. And going all the way back to the early nineties, the Fed has misunderstood and misdiagnosed the problem. It is a popular pastime to criticize the Germans for their inflation fixation. Well, history will identify a much more dangerous fixation on deflation that spread from the U.S. to much of the world.

I see sinking commodities prices as one more data point supporting the view of failed central bank policy doctrine. For one, it confirms that unprecedented monetary stimulus is largely bypassing real economies on its way to Bubbling global securities markets. I also see faltering commodities markets as confirmation of my “crowded trade” thesis. For too many years (going back to the 90’s) the Fed and global central bank policies have incentivized leveraged speculation. This has fostered a massive inflation in this global pool of speculative finance that has ensured too much market-based liquidity (“money”) has been chasing a limited amount of risk assets. Speculative excess today encompasses all markets, including gold and the commodities. Over recent months, these Bubbles have become increasingly unwieldy and unstable. Commodities are the first to crack.

IMF head Christine Lagarde this week made an interesting comment: “Thanks to the actions of policymakers, the economic world no longer looks quite as dangerous as it did six months ago.” I was convinced things looked dangerous on a globally systemic basis this past summer, yet policymakers and analysts at the time admitted to only a bout of manageable stress in Europe. Well, in the past six or so months we’re seen the “do whatever it takes” Draghi market backstop, an unprecedented $85bn a month of Fed QE and now the Bank of Japan’s samurai version of “do whatever it takes” “shock and awe” $80bn monthly printing. Economies aren’t buying it.

The Bank of Japan’s Kuroda positioned himself as the poster child for central bankers gone wild. When central banks imitate Dirty Harry and others are determined to shock and awe the marketplace, well, you have to think things have gone far off kilter. When the Fed obfuscates and ties massive money printing to a politically palatable unemployment rate – things have gone too far. When policymakers, economists and pundits around the globe ramble on and on about low inflation and completely disregard dangerous asset inflation and Bubbles, things have definitely gone too far.

Japanese 10-year yields jumped 8 bps this week. The markets are keen to gauge whether the BOJ just went too far in the minds of investors in long-term Japanese debt. The Chinese Credit system is in the midst of a historic year of Bubble excess. Have things gone so far that Chinese officials will finally respond with meaningful (and Bubble-jeopardizing) tightening measures? In Cyprus, a country of less than a million faces bailout costs of $23bn, more than a year’s GDP. Have these bailouts about gone far enough – for the troubled countries sickened by “austerity” measures and “troika” control? And how about the others sick and tired of writing bailout checks and participating in a dysfunctional “transfer union”? How far is too far for runaway U.S. equities, bond and asset Bubbles that bring new meaning to the phrase “systemic Credit and economic Bubble”? How long will the Bank of Japan’s shot of opium numb the world’s senses?

From my perspective, recent desperate measures from the BOJ, Fed and ECB put an exclamation mark on twenty years of failed monetary management. The view that this ends rather badly is confirmed by unrelenting bids for bunds, Treasuries and “safe haven” sovereign debt around the globe. It is further confirmed by the widening gulf emerging between highly inflated and speculative global securities markets and notably moribund (and increasingly stimulus-resistant) real economies.

Forecasting Bubble behavior is a tricky, tricky business. Yet I’ll stick with the view that Europe is the initial major crack in the “global government finance Bubble.” And while Draghi resuscitated “risk on” throughout Europe, this actually works to exacerbate fragilities as that region struggles with a deep and evolving crisis. I’ll stick with the view that five years of global financial excess has helped push China to the status of a crazy dangerous Bubble. And I see no reason to back away from the analysis that the emerging economies in general suffer from a dangerous Bubble mix of rampant Credit excess, problematic imbalances and deteriorating economic performance. Moreover, I’m content with the view that the “global leveraged speculating community” is one huge accident in the making.

Perhaps the crack in commodities markets is indicative of a confluence of unfolding faltering Bubble risk in Europe, China, the emerging markets and the hedge fund community. The Bank of Japan’s obtrusive market intervention provided a huge windfall for some while hammering others, not unlike recent obtrusive interventions by the ECB and Fed. All along the way, global risk markets become increasingly unstable - if not hopelessly dysfunctional. At this point, risks associated with repeated attempts to cure post-asset Bubble stagnation with “helicopter money” should not be all that difficult to discern.