By Doug Noland at Credit Bubble Bulletin
“The US economy has made tremendous progress in recovering from the damage from the financial crisis. Slowly but surely the labor market is healing. For well over a year, we have averaged about 225,000 jobs (gains) a month. The unemployment rate now stands at 5%. So, we’re coming close to our assigned congressional goal of maximum employment. Inflation which my colleagues here, Paul (Volcker) and Alan (Greenspan), spent much of their time as chairmen bringing inflation down from unacceptably high levels. For a number of years now, inflation has been running under our 2% goal, and we are focused on moving it up to 2%. But we think that it’s partly transitory influences, namely declining oil prices and the strong dollar that are responsible for pulling inflation below the 2% level we think is most desirable. So, I think we’re making progress there as well. This is an economy on a solid course – not a bubble economy. We tried carefully to look at evidence of potential financial instability that might be brewing and some of the hallmarks of that – clearly overvalued asset prices, high leverage, rising leverage, and rapid credit growth. We certainly don’t see those imbalances. And so although interest rates are low, and that is something that can encourage reach for yield behavior, I certainly wouldn’t describe this as a bubble economy.” Janet Yellen, April 7, 2016, International House: “A Conversation with Janet Yellen, Ben Bernanke, Alan Greenspan and Paul Volcker”
From my analytical perspective, unsustainability is a fundamental feature of “Bubble Economies.” They are sustained only so long as sufficient monetary fuel is forthcoming. Over time, such economies are characterized by deep structural maladjustment, the consequence of years of underlying monetary inflation. Excessive issuance of money and Credit are always at the root of distortions in investment and spending patterns. Asset inflation and price Bubbles invariably play central roles in latent fragility. Risk intermediation is instrumental, especially late in the cycle as the quantity of Credit expands and quality deteriorates. Prolonged Credit booms – the type associated with Bubble Economies – invariably have a major government component.
Japanese officials in the late-eighties recognized the risks associated with their Bubble economy and moved courageously to pierce the Bubble. Outside of that, few policymakers have been even willing to admit that Bubble Dynamics have taken hold in their systems. Apparently, only in hindsight did U.S. monetary authorities recognize the Bubble component that came to exert pernicious effects on the U.S. economy in the late-eighties, later in the nineties and again in the 2002-2007 mortgage finance Bubble period. I would strongly argue that the U.S. has been in a “Bubble Economy” progression for the better part of thirty years, interrupted by financial crises relatively quickly resolved by aggressive governmental reflationary measures. And each reflation has been more egregious than the previous, with resulting booms exacerbating underlying financial and economic maladjustment.
Chair Yellen stated that the U.S. “is an economy on a solid course – not a bubble economy” – “we tried carefully to look at evidence of potential financial instability that might be brewing.” That the Fed has for seven post-crisis years clung to near zero rates and a $4.5 TN balance sheet (with reassurances that it can grow larger) argues against such claims. That the Fed rather abruptly backed away from its 2011 “exit strategy” and repeatedly postponed “lift off” due to market instability rather clearly demonstrates the Fed’s underlying lack of confidence in the soundness of the markets and real economy.
I have argued that the more systemic a Bubble the less obvious it becomes to casual observers. By the late-nineties, the “tech” Bubble had turned rather conspicuous (although the Fed and the bulls still rationalized with claims of New Eras and New Paradigms). While having quite an impact on the technology, telecom and media sectors, these relatively narrow Bubble distortions had yet to cultivate more general structural impairment throughout the economy.
The mortgage finance Bubble was a much more powerful Bubble Dynamic, clearly in terms of Credit expansion, economic imbalances and systemic impairment. Alan Greenspan nonetheless argued that since real estate was driven by local factors, a national housing Bubble was implausible. Only in hindsight was the degree of systemic “Bubble Economy” maladjustment recognized.
It’s now been seven years since my initial warning of an inflating “global government finance Bubble” – the “Granddaddy of All of Bubbles.” This Bubble did become systemic on a globalized basis, ensuring the strange dynamic of a somewhat less than conspicuous global Bubble of historic proportions. Over the past eight years, global Credit growth has been unprecedented – driven by an extraordinary expansion of government borrowings. The inflation of central bank Credit has been simply unimaginable. Global asset inflation has been extraordinary – especially in securities markets and real estate.
The expansion of Chinese Credit has been greater than I previously imagined possible. Hundreds of billions – perhaps Trillions – have flowed out of China, with untold amounts flowing into the U.S. (real estate, securities and M&A). For that matter, I believe huge inbound flows have been inflating U.S. securities and some real estate markets, especially “money” fleeing bursting EM Bubbles.
Indeed, extraordinary international financial flows are fundamental to the global government finance Bubble thesis, flows that I believe are increasingly at risk. Along with Bubble flows from China and out of faltering EM, I believe speculative flows grew to immense proportions. And, importantly, the massive global pool of destabilizing speculative finance has been inflated by the proliferation of leveraged strategies. Chair Yellen may not see “high leverage,” yet on a globalized basis I strongly believe speculative leverage reached new heights over recent years. “Carry trade” speculation – borrowing in low-yielding currencies (yen, swissy, euro, etc.) – has proliferated over recent years, especially after the 2012 “whatever it takes” devaluations orchestrated by the European Central Bank and Bank of Japan.
How much of the resulting speculation-related liquidity ended up flowing into U.S. markets and the American economy? What are the consequences – to the markets and overall economy – if these flows stop – or even reverse? Moreover, I suspect unprecedented amounts of leverage have accumulated throughout the U.S. Credit market – Treasuries, corporates and munis. And Wall Street has definitely been hard at work in recent years creating all varieties of instruments, products and strategies that benefit from the combination of ultra-low rates and leverage (certainly including higher-yielding equities).
Over time, Bubble Economies become increasingly vulnerable to economic stagnation, Credit degradation and asset price busts. Bubbles are fueled by Credit excesses that distort risk perceptions and resource allocation. Credit and asset price inflation will incentivize speculation, another key dynamic ensuring misallocation and malinvestment. In the end, Bubbles redistribute and destroy wealth. Major Bubbles will tear at the threads of society.
It remains my view that the global Bubble has burst. The recent rally in global risk markets restored hope that things remain central bank-induced business as usual. This week provided support for the view that the respite from heightened volatility and vulnerability has likely run its course.
Global equities were under pressure this week, while safe haven bonds and gold rallied. Japan’s Nikkei dropped 2.1%, increasing 2016 losses to 16.9%. The German DAX fell 1.8%, boosting y-t-d declines to 10.4%. Spanish stocks were down 2.0% (down 11.7%), and Italian shares fell 1.5% (down 18.3%). Ten-year German bund yields dropped to nine basis points
Ominously, global financial stocks continue to trade poorly. After the recent notably unimpressive rally, selling of global bank and financial shares has resumed. The STOXX Europe 600 Bank index sank 3.5% this week, pushing 2016 losses to 24.7%. This week’s 3.1% decline boosted Italian bank stock y-t-d losses to 35.4%. Deutsche Bank has returned to February lows (down 34%). European bank stocks generally are quickly approaching February lows. Italian bank stocks traded this week slightly below lows from the February tumult period. Hong Kong’s Hang Seng Financial index was down 2.0% this week (down 12.6%). Here at home, U.S. bank stocks (BKX) dropped 3.6%, increasing y-t-d declines to 14.7%. The security broker/dealers (XBD) sank 6.2%, increasing 2016 losses to 13.7%. Goldman Sachs closed Friday at about $150, after trading as high as $200 this past November.
I would argue that currency market instability has negative portents as well. The Japanese yen surged 3.2% this week to a 17-month high. The yen gained about 5% versus the Australian dollar, New Zealand dollar and Mexican peso. It’s worth noting that the Chilean peso, Colombian peso, Turkish lira and Brazilian real were all under pressure, as the recent EM rally appears increasingly vulnerable.
A few headlines were telling: “Japanese Yen Trade Mystifies and Could Penalize” (CNBC); “Stunning Rally in Japanese Yen Risks Too Little Faith in BoJ Policy Genius” (Australian Financial Review); and “Japan Faces Trouble Controlling Yen Rise” (Reuters).
It is no coincidence that the yen is rising as global financial stocks are sinking. Both are indicative of market fears that global policymakers are losing control. The yen has rallied significantly in the face of the BOJ imposing punitive negative interest rates. The euro has also risen to a six-month high in spite of the ECB’s surprise one-third increase in its QE program.
Keep in mind that both the BOJ and ECB boosted stimulus, as the Fed assumed a more dovish posture, in a concerted response to heightened global market instability. These measure did incite a robust short squeeze, an unwind of bearish hedges and a general rally in global risk markets. Yet markets are already again indicating waning confidence that policymakers actually have things under control.
The Japanese have lost control of the yen, which has hurt prospects for Japan’s equities and overall economy. It has also turned various leveraged strategies on their heads, portending pressure on the global leveraged speculating community more generally. Meanwhile, the half life of Draghi’s latest “shock and awe” has proved alarmingly short. Boosting the ECB’s QE program reversed what had been a significant widening of Credit spreads throughout Europe. It’s worth noting that European periphery spreads (to German bunds) widened meaningfully this week. Portuguese spreads surged 48 bps and Greek spreads widened 41 bps. Italian spreads widened 13 bps and Spanish spreads increased 12 bps.
I’ve excerpted below from my recent analysis of the Fed’s Q4 2015 Z.1 “flow of funds” report:
Treasury Securities ended 2007 at $6.051 TN. By 2015’s conclusion, Treasuries had inflated to $15.141 TN, an increase of $9.090 TN, or 150%, in eight years. It’s worth noting that Agency Securities ended 2015 at $8.153 TN, having now almost recovered back to 2008’s record high.
Total Debt Securities (Treasuries, Agencies, Corporates & muni’s) ended 2015 at a record $38.741 TN. Total Debt Securities have increased $11.3 TN, or 41%, from what had been 2007’s record level. Total Debt Securities as a percent of GDP ended 2015 at a near record 217% of GDP. For perspective, this ratio began the eighties at 66%, the nineties at 110%, and the 2000’s at 140%.
Equities ended 2015 at $35.687 TN, or 199% of GDP. This compares to Equities/GDP of 44% to begin the eighties, 67% to start the nineties and 200% to end Bubble Year 1999. Combining Debt and Equity Securities, Total Securities ended 2015 at a record $74.428 TN. This was up 40% from 2007 (a then record 366% of GDP) to 415% of GDP. This compares to 109% to begin the eighties, 178% to start the nineties and 341% to end the nineties.
Household… Assets ended 2015 at a record $101.306 TN, up $2.953 TN during the year. Household Assets have increased almost 50% since the end of 2008. …Household Net Worth jumped another $2.607 TN last year. For the year, Household holdings of Real Estate increased $1.562 TN (to a record $25.267 TN), with Financial Assets up $1.171 TN (to a near-record $70.327 TN). Household Net Worth as a percentage of GDP ended 2015 at 484%. For comparison, Household Net Worth to GDP began the nineties at 379%, ended 1999 at 446% and closed Bubble Year 2007 at 461% of GDP.
Total Non-Financial Debt increased $1.912 TN in 2015 to a record $45.149 TN. NFD has increased $10.218 TN, or 29%, over the past seven years. NFD to GDP ended 2015 at a record 252%. For perspective, this ratio began the eighties at 138%, the nineties at 179% and the 2000’s at 179%.