By David Stockman as originally published on Contra Corner and reprinted here with permission
Among the many evils of the Fed’s Bubble Finance regime is what might be called the Truman Show effect. Like the Jim Carrey character who was unknowingly living a fake life on a movie set in the 1998 film, Wall Street players—-including the financial press—have been prospering inside the Bubble so long that they do indeed think it is reality.
Or more to the point, they have forgotten (or never learned ) the laws of honest markets and sound money. They therefore have no clue that the foundation of the system is rotten to the core and that the current debt and speculation ridden financial markets are an accident waiting to happen.
We had a close encounter with the Truman Show effect yesterday during an appearance on CNBC. The thirty-something anchors were shocked to hear that Washington’s upcoming $1.8 trillion double whammy (FY 2019 Treasury borrowing of $1.2 trillion plus Fed QT bond-dumping of $600 billion) in the bond pits might generate a resounding “yield shock”, thereby upending the current huge stock market bubble where 4%+ bond yields are most definitely not priced in.
The younger of the anchors (age 32) thought the $1.8 trillion was not a problem because the soaring debt and the Fed’s balance sheet shrinkage plan have been well telegraphed and will shock no one. Yes, and as we were tempted to reply, parking on a rail crossing and knowing that a freight train is barreling down the tracks is not likely to forestall the carnage.
Likewise, the senior anchor further averred that we’ve been there before and that “awhile back” $1 trillion dollar deficits were absorbed with ease. No carnage!
To little avail, of course, we pointed out that “awhile back” came at the bottom the Great Recession when private investment had collapsed and the Fed and other central banks had been running their printing presses red hot. During the nine years of so-called recovery thereafter, which saw huge but slowly shrinking fiscal deficits, the Fed had purchased $3.5 trillion of government and GSE securities and central banks globally had absorbed a total of $15 trillion just since 2008.
But that was at the bottom of the business cycle when the central bankers were buyers of bonds. By contrast, now we are at the top of the cycle heading into year #10 of recovery and the central bankers are becoming sellers.
So the law of supply and demand, which had never been suspended, will be leveraged in the opposite direction. In the cycle ahead, the central banks will be in the business of disgorging, not absorbing, the supply of bonds—even as the drunken sailors of the Trump/GOP have done the historically unthinkable.
That is, they are massively increasing the fiscal deficit (to nearly 6% of GDP in FY 2019) at the tail end of what would otherwise be the longest business expansion in history. People in the pre-Truman Show days, of course, knew that to be the height of folly.
Not only that, but we also pointed out that there is every reason to believe that central bank front-runners function as a powerful financial turbo-charger: They drove bond prices even higher when the were buying what the Fed and other central banks were buying during the QE phase. But now they will surely drive prices lower and yields far higher as these leveraged bond speculators pivot to selling what the Fed is selling.
Here’s the thing. The cult of Keynesian central banking is so deeply embedded in Wall Street and the financial media that it amounts to a classic suspension of disbelief. To wit, nothing much matters except: (1) what the Fed says it has done, no matter how untrue as in the case of the flat-lining main street economy, as we have documented in this series; and (2) what the Fed says it will donext, no matter how untested and incompatible with the basic laws of markets and sound money.
To the latter end, the Fed now says that it can deftly guide the last ten-year’s foray in “extraordinary policy” into a soft, trouble-free landing. Yet that very proposition—which the CNBC anchors in the clip have fallen for hook, line and sinker—actually underscores the extreme danger ahead.
To wit, the Fed’s arrogant confidence is based on an utterly false understanding of what a decade of massive QE and ZIRP actually accomplished. Our Keynesian central bankers think they lifted the main street economy from the edge of depression to a robust full-employment prosperity. Yet the latter didn’t happen and the ragged recovery that we have experienced was due to the inherent regenerative powers of capitalism.
Stated differently, what the central bankers did levitate was a massive financial bubble and systematic deformation of the capital and money markets. Not only does that incipient financial volcano remain off their radar screens entirely, but our feckless monetary central planners have actually leapt to the opposite conclusion.
That is, to the confused belief that the only thing they need to worry about is the main street economy, and that the latter is now resilient enough to absorb a steady and well-telegraphed “normalization” of interest rates.
To the contrary, of course, they main street economy has nothing to do with it because the Fed’s extraordinary stimulus polices never really left the canyons of Wall Street. So what they are actually fixing to do is slam the ultra-fragile and hideously over-extended money and capital markets with a monetary pile-driver (i.e. quantitative tightening and the massive drainage of cash from the bond pits).
Needless to say, when it happens, the Truman Show inhabitants of the type featured below will be shocked, and not in Captain Renault’s sense of the word.
That gets us back to the great disconnect between main street and Wall Street, and the Truman Show aspect of it could not be more transparent. After nearly a decade of massive monetary stimulus, here is a reminder of what the Fed has actually produced since the pre-crisis peak in Q4 2007: Namely, a58% inflation-adjusted gain in the S&P 500 index versus a 2% gain in industrial production, 6% gain in total labor hours worked, an 8% gain in real corporate profits, a 12% gain in productivity and a 15% gain in real final sales.
Self-evidently, the Fed’s “stimulus” worked its purported magic on the 58% gain in Wall Street, not the tepid 2-15% gains on main street. Accordingly, the Fed is taking false comfort from a U-3 unemployment rate of 4.1%, which is basically noise; and a meager 1.4% annual rate of gain in real final sales (a mere one-third of the historic average) over the last decade. Even the latter, of course, reflected the regenerative powers of capitalism, not the Fed’s massive flow of fiat credit into Wall Street or the ultra-cheap interest rates that fueled rampant carry trade speculation.
At the end of the day, what really happened is that the historic credit market channels of monetary policy transmission to main street didn’t work. As we have previously demonstrated in the case of the household sector, it was already at Peak Debt by the time of the financial crisis, meaning that eight years of ZIRP or near ZIRP stimulated no incremental borrowing at all. In fact, the household sector has modestly deleveraged since 2008.
The story is slightly more complicated with respect to the business sector, but the outcome is exactly the same: The “stimulus” got recycled back into the canyons of Wall Street, where it then helped inflate the mother of all financial bubbles.
The chart below shows the first stage of cause and effect. Since the turn of the century the benchmark corporate bond rate (yellow line) has dropped from just under 8.0% to around 3.5% at the present time. Not surprisingly, that did stimulate a rip-roaring spree of business borrowing (nonfinancial corporate and non-corporate).
In fact, total business debt more than doubled, rising from $6.5 trillion at the turn of the century to $14.2 trillon by the end of 2017. Had that mainly gone into productive investment and expansion of the capacity for future production growth, it would have validated the primitive Keynesian pump-priming model on which the Fed’s ZIRP and QE policies are essentially based—-notwithstanding all the mumbo-jumbo about some mysterious economic elixir called “accommodation”.
Alas, the Keynesian pump didn’t prime much at all, as documented below. Accordingly, now that it has come time to normalize interest rates, the worst of both world’s pertains. The business sector’s earnings capacity has not been increased materially, but it is now lugging around $14.6 trillion of debt, meaning that every 100 basis point increase in interest rates will slam US businesses with $150 billion of higher interest expense.
The next chart demonstrates how the Keynesian credit channel got short-circuited in the business sector. In a word, while business debt grew at a 5.0% compound rate over the last 17 years, CapEx expanded by only 3.2% per annum and investment in business inventories by only 2.95% per year.
Needless to say, over an extended period of time, those growth rate differentials make a tremendous cumulative difference. To wit, by 2017, business debt stood at 230% of its year 2000 level compared to capital spending at just 173% and inventories at 165%.
Needless to say, had debt grown at the same rate as investment during the last 17 years, business debt today would stand at $11 trillion, not $14.1 trillion. Nor is there any mystery at to where the $3 trillion extra went.
To wit, it flowed back into Wall Street in the form of corporate financial engineering deals, and most especially stock buybacks, as is so dramatically crystalized in the chart below.
In the case of the S&P 500 alone, which represents less than 60% of the total business sector, buybacks have soared from $50 billion per year in 2000 to around $500 billion per year in the recent past; and based on the $171 billion run-rate of the first two months of 2018 could in theory hit$1 trillion during the current year.
The resulting artificial bid for stock obviously boosted share prices significantly and is one of the many channels by which the Fed’s massive emission of fiat credit was recycled back into the canyons of Wall Street.
Still, it was only one of the numerous contributing factors that turned Wall Street into the equivalent of a financial Truman Show.
In Part 6 we will treat with exactly what has been happening on the stage set where Wall Street once stood, and where an artificially erected casino now totters.