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Why Now?

Of bubble dynamics and ultimate ironies.

Investors are simply going to have to learn to live with a new reality. And we may finally get to see what they are made of. Proof positive, one way or another, whether this is all merely a financial bubble or not. The global economy may experience periodic ups and downs but what monetary policy makers are beginning to form a consensus around is things just aren’t as bad as official interest rates suggest.

That’s from a Thursday missive penned by former trader Richard Breslow who writes a daily column for Bloomberg.

Implicit there is the notion that central banks (and especially the Fed) are no longer intentionally moving the goal posts. They are no longer intentionally chasing an elusive target in the interest of avoiding the possibly unpleasant consequences that may go along with normalizing policy.

Everyone (i.e., institutional investors all the way down to Joe ETF) remembers vividly how, for years, policymakers obfuscated at every post-meeting press conference. Academic acrobatics were employed in the service of explaining why accommodative policy was still necessary no matter how good the data seemed. One of the great ironies of the post-crisis monetary policy regime was that naysayers and those of a doomsday persuasion saw policymakers turn the tables on them. “The economy is not as good as the numbers suggest!”, the skeptics would shout. The tacit answer from central bankers was: “You’re right and that’s why we’re going to keep policy accommodative.”

Of course the rejoinder from the skeptics was that policy accommodation was leading to bubbles, but at that point, they were talking themselves in circles;  either the economy isn’t good and needs stimulus or it is good and it doesn’t need stimulus. If the economy isn’t good and fiscal stimulus isn’t an option because austerity is en vogue, well then either you pull the monetary policy lever, or else you get a deflationary spiral and a depression. If you choose the latter, the world is running an experiment in creative destruction and if that experiment goes awry, well then see Hobbes.

Playing innocent

As you can probably surmise from the above (and as regular readers are aware), I think we need economists running the show and I think we need to at least pretend like they know what they’re doing. I also firmly believe we need to allow Wall Street to layer financialization on top of a system run by economists. I know that sounds dangerous and I’m fully aware of the extent to which that setup has, in one way or another, precipitated every horrific bust in the history of modern finance. But there is no better expression of why we need that system than the following classic quote from the film Margin Call (this is from a scene in the film that finds a senior trader explaining to a junior risk management associate why the current system is necessary):

Listen, if you really wanna do this with your life you have to believe you’re necessary and you are. People wanna live like this in their cars and big houses they can’t even pay for, then you’re necessary. The only reason that they all get to continue living like kings is because we’ve got our fingers on the scales in their favor. I take my hand off and then the whole world gets really fair really  quickly and nobody actually wants that. They say they do but they don’t. They want what we have to give them but they also wanna, you know, play innocent and pretend they have no idea where it came from.

That is the cold, hard reality of things. The problem is that, as alluded to above, this setup invariably leads to ever larger booms and busts. The larger the busts, the larger the policy response needs to be. The next bubble has to be large enough to subsume the bust that resulted from the previous bubble, so what you end up with is a kind of spiraling bubble machine.

Eventually, we’ll get a bust so large that policymakers will not be able to engineer a new bubble large enough to completely subsume it and some form of forced creative destruction will play out. But what I would encourage you to remember is that people have been predicting that after every bust for as long as I’ve been around, and we haven’t gotten there yet. Policymakers and Wall Street have always engineered a new bubble large enough to make everyone forget the last one, and that’s where we found ourselves headed into 2018.

The ‘ammo’ problem

The issue, though, is that the unprecedented nature of the monetary policy response to the 2008 crisis involved pushing rates to zero and below and monetizing everything from risk-free assets to corporate bonds to, in Japan’s case, ETFs. The question, then, was whether we had reached the theoretical limits of monetary policy.

At the same time, the post-crisis regulatory regime left Wall Street hamstrung in its capacity to mitigate certain adverse scenarios. There is no better example of this than the enormous disconnect between, on one hand, the amount of duration parked in funds, and on the other, dealer books. Here’s one representation of that:

Oops

(Deutsche Bank)

Investors have, to quote Goldman, “leaned into the liquidity premium” as the central bank-inspired hunt for yield gathered steam over the last five years. But if Wall Street isn’t willing to lend its balance sheet in the event illiquid holdings need to be sold to raise cash in a pinch, there will be no market for some of the illiquid assets accumulated as a result of the now decade-long hunt for yield.

Also bear in mind that prior to Donald Trump’s election, the Western world had developed an affinity (almost an obsession) with austerity. That was the legacy of the European debt crisis. There wasn’t much reason for central bankers to believe things were likely to change in that regard.

Realizing all of the above, developed market central banks went into 2018 with a mind towards normalizing policy (in the U.S., the passing of the baton to Jerome Powell meant the Fed would accelerate the normalization process that was already in the works). The distortions brought about by years of accommodation were starting to become too glaring to ignore and the frustrating part for the Fed was that the 2017 equity rally had conspired with still accommodative policies in Europe and Japan to push U.S. financial conditions to the easiest on record despite multiple rate hikes.

The risk headed into this year was that in the event something went “wrong” (where that means either a bubble burst somewhere or the economic data started to roll over), central banks would find themselves confronting an acute situation without much in the way of ammunition. The ECB got an unwelcome dress rehearsal of that in Q1 when the eurozone economic data suddenly took a turn for the worst, raising the specter of “quantitative failure.”

It was always a financial bubble

There really isn’t much ambiguity about whether “this is all merely a financial bubble or not” (to re-quote the above-mentioned Richard Breslow). The whole point of post-crisis monetary policy was to create a financial bubble large enough to subsume the crisis that was itself the result of the previous financial bubble.

Obviously, the global reflation effort was ultimately aimed at resurrecting the real economy, but this was always – always – dependent upon the fabled “wealth effect.” The assumption was that if you unleash a liquidity tsunami and inflate the value of financial assets, that will filter through to the real economy. And it did. Only not on a one-for-one basis.

Policymakers grossly underestimated the efficiency of the transmission channel from accommodative policy to financial assets and grossly overestimated the efficiency of the transmission channel from asset price inflation to the real economy. At some point (probably around mid-2016) it became readily apparent that waiting around for more robust real economic outcomes was an exercise in futility – a hopeless effort to deny the law of diminishing returns. Meanwhile, financial assets continued to inflate, and the disconnect between those assets and real economic outcomes widened further.

Why now?

The delay in normalizing monetary policy wasn’t so much the result of central banks believing the global economy was bad enough to justify current policy rates and ongoing asset purchases. Rather, the delay was attributable to the overriding tendency to avoid relinquishing control until it was absolutely necessary.

The ultimate irony is that the urgency inherent in current efforts to give up control of markets (i.e., to normalize policy) is a reflection of policymakers’ desire to ensure that they have the capacity to retake control later on the way to engineering another, larger bubble spectacular enough to swallow the fallout when the bubble they just finished inflating finally bursts.

So when folks tell you that as an investors, you’re “simply going to have to learn to live with a new reality”, you can at least take solace in the fact that this “new reality” (where that means less accommodation) is only a temporary state of affairs, necessary only to the extent it gives policymakers the capacity to retake the reins later.


 

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5 comments on “Why Now?

  1. Why now? Because TCJA makes it too obvious that the central banks will get played at every opportunity. They have no choice now but to take their chips, funded by public money, off the table.

  2. USA GDP growth for the past 10 years will finish 2018 below the 1930s. Things are fantastic, just like 1993 Japan. Ya, tighten the screws.

  3. Great post, H. Next post suggestion–Where are we in time in reloading?

    On a not unrelated topic. If international capital flows continue to support U.S. credit, are we not looking in the wrong place (U.S. credit stability) to ‘justify’ that the sell-off in equities is overdone?

    This time is different. Maybe it always is. Conclusion: U.S. equities lower.

  4. The perfect Halloween post. The Bubble Zombie will rise again, but must die first to be reborn. spookie maniacal laughter

    Reminds me also of the Matrix. The illusion is better than the Hobbsian reality.

  5. Thomas Higgins

    We have experienced several bubbles over the course of the last 20 years: Dot Com, Sub-Prime, Real Estate/FAANG. And each is an order of magnitude larger than the one preceding it.

    These bubbles are enabled by the Federal Reserve, which has long pursued a zero interest rate policy (“ZIRP”) and has (since the GFC) purchased assets on a massive scale.

    Some suggest that these serial bubbles (and therefore the Fed policies that enabled them) are a bad thing. Eventually a bubble will pop, causing catastrophic harm. And the larger the bubble, the worse the fallout will be.

    Mr. Heisenberg argues to the contrary. We haven’t experienced disaster yet, implying that it may never happen. Moreover, increasingly large bubbles are a good thing, since they are big enough to not only absorb the damage caused by the preceding (deflated) bubble but also create a new “wealth effect.”

    Now, however, the Federal Reserve has decided on a complete reversal of policy. It had prevented massive deflation by gorging itself on some $3-trillion of iffy “assets,” paying par for things that could not otherwise be liquidated except at a steep discount. Rather than continuing that approach, the Fed is now shrinking its balance sheet. And instead of continuing ZIRP indefinitely it is gradually normalizing rates.

    Not surprisingly, Mr. Heisenberg disagrees with this about-face. Should a crisis come, then the Fed can normalize rates, if that’s what they really want to do. In any case, an economist should be in charge of pursuing this normalization program, not a lawyer like current Fed Head Powell.

    I disagree with Mr. Heisenberg at every turn. He tells us that each of these bubbles is good because it neutralizes the fallout from previous misallocations of capital and creates a new wealth effect, but do they really?

    Let’s begin by asking the question: What do we mean by the term “wealth effect”?Part of it is preventing the creation of “negative wealth.”

    During the years leading up to the GFC there were huge misallocations of capital. The most famous example is CDOs created out of huge numbers of sub-prime mortgages, but there are other instances.

    A number of the big Wall Street investment banks that had been making these dodgy investments realized that they were taking terrible risks. Not only were their bets long shots but they were highly leveraged, so a decline of even a few percent would have wiped them out. It was okay, however, because they took out “insurance,” most famously from AIG but from a lot of others too.

    AIG did a poor job of underwriting, so they were not being adequately compensated for the risk they were taking. (This is not surprising, since they are primarily a life insurance company.) To compound matters, they wrote a lot more insurance than justified given the size of their balance sheet.

    When the Subprime Crisis arrived, first on the hit parade was AIG and its fellow insurers. After it finished wiping them out, the Crisis was scheduled to take down all the players that had made those dodgy bets. And, because all the big financial institutions are connected, the entire global financial system would ultimately collapse.

    However, Treasury and the Federal Reserve intervened. The investment banks lived to gamble another day, and we were spared from a Greater Depression that would have reduced precipitously the amount of wealth worldwide.

    We have talked about the negative wealth effect that the Fed prevented. Now let’s look at the positive wealth effect that they caused.

    The Fed lowered interest rates to virtually zero. This allowed the banks to build up their balance sheet by borrowing a mountain of cash at almost no cost and then loaning it to the Fed at above-market rates.

    Of course, a zero interest rate causes a huge amount of monetary inflation, and all of that Monopoly money had to go somewhere. A lot went into the housing, bond and stock markets, raising prices precipitously in the process.

    That’s nice. The Fed saved us from the Greater Depression, and made homeowners and investors — not to mention the banks — rich. But did they really, or was that just an illusion?

    We noted earlier that the Fed gorged itself on trillions of dollars of Treasury instruments and questionable assets. For reasons that we will discuss later, now the Fed is vomiting them up. They do this by converting these assets to cash. Thus, an ever-increasing amount of cash that had been in the economy will now be sitting on the Fed’s balance sheet, and a lot more Treasuries will be in the market. This increased supply of Treasury instruments will bid up rates. None of these factors is good for the housing and financial markets.

    To compound matters, the Fed is slowly but inexorably normalizing rates. There are a number of projects that cash flow only because interest rates are at historical lows. As rates increase so will the number of bankruptcies. That will suck a lot more money out of the economy.

    Okay, the positive wealth effect is transitory, but what about the Greater Depression? The Fed saved us from zillions of dollars going poof, unemployment on a massive scale….

    Well, let’s see. The Fed bought a bunch of garbage assets at par. It’s impossible to know for sure, but they probably overpaid by at least $1-trillion. Then they paid their member banks above-market rates on a mountain of cash. How much did that cost? Another trillion? As we mentioned, trillions of dollars are being vacuumed out of the economy and into the Fed’s balance sheet, taking it out of circulation indefinitely. Then there’s the impending bankruptcies….

    I know what you’re thinking: “All of this is chump change compared to the fallout that we would have experienced had the Fed allowed a Greater Depression to take hold.” I’m not so sure about that.

    A few months ago Mr. Heisenberg informed us of the huge amount of paper losses incurred when the Tennessee state pension system’s Turkish bonds went south. Presumably, this fund is administered by people holding an MBA or a similar qualification. They must have understood the risk when they bought these things. Did they lose their minds?

    You have to remember that pension funds typically need to earn about eight percent per annum to fulfill their obligations. Because of the Fed-induced low rate regime, these funds must choose between an ever-growing hole in their balance sheet or buying junk bonds and the like and hoping they don’t go bust. And of course the Tennessee retirement system is not the only pension system to place that bet. In the not-too-distant future, a lot of pension funds (and other entities in a similar situation, like annuity companies and foundations) will forget about return on investment and start worrying about return OF investment. In all likelihood, a number of bankruptcies will follow.

    Of course, a lot of retirees have also gone further out on the risk spectrum in search of yield. They, too, will experience catastrophic losses.

    This will be akin to having an elephant die on your doorstep. It will probably cost multiple trillions to clean this mess up.

    So no, by creating the most recent bubble the Fed did not cause the ill effects of the GFC to magically disappear. They merely transferred the burden from the Wall Street investment banks to the taxpayers and retirees.

    Next Mr. Heisenberg tells us that if the Fed really wants to normalize rates and shrink the balance sheet, it should wait to do so until the next crisis comes, if it comes.

    This misses the point. It’s not a question of whether a new crisis will appear, because the old one never really left. The Fed dropped the equivalent of a mountain of rocks on the financial Godzilla. Did it kill him? No, it just locked him away from public view. Out of sight, out of mind. But Godzilla is going to break loose, and when he does boy is he going to be mad!

    Admittedly, Powell is more given to plain speaking than his three immediate predecessors: Greenspan, Bernanke and Yellen. Even with him, however, we have to read the tea leaves.
    The Fed’s thinking seems to be along these lines. During the GFC, they tried all sorts of measures but (as we have seen) only two worked even somewhat well: asset purchases and ZIRP. At some point they will be presented with a bigger, stronger Godzilla. When that happens, they better have the ammunition that they need to deal with him.

    Therein lies the problem. The Fed’s ability to swallow dodgy assets is limited. They have been vomiting up the GFC-era misallocations so that later they can lap up the current crop.

    Funny thing, the bigger the bubble the more you have to drop interest rates to deal with the fallout. I don’t know, but I wouldn’t be surprised if the Fed has to lower 600, maybe even 1000, basis points when the Greater Depression rolls into town. This presents a problem, considering that rates are effectively zero.

    This means they have to raise rates so that they can lower them later. That is easier said than done. A few years ago, when the Fed tried to get ahead of the curve, the markets threw a Taper Tantrum. The Fed blinked, halting their normalization program. They’ve resumed, but this time they are raising gradually (100 basis points per year) so as not to spook the markets. You see their problem: at this rate it will take at least six years to build up enough ammunition to knock out Godzilla when he finally bursts free from his cage. That is why the Fed can’t just wait to normalize until faced with immediate danger, as Mr. Heisenberg urges.

    The final argument is that if the Fed is intent on pursuing a course of normalization, we should have an economist in charge instead of attorney Powell. Mr. Heisenberg doesn’t say why so we’ll have to speculate.

    Elsewhere on this site I have spilled gallons of virtual ink driving home the point that economics is not rocket science, so I’ll not belabor that now. The essence is that far from being a hard science like chemistry or biology, economics is more akin to one of the social sciences, like sociology. Not surprisingly, economics has a hard time engineering a desired outcome. As we have seen, the only two methods they’ve found for dealing with crisis are the blunt instruments of asset purchases and rate decreases.

    And economists aren’t rocket scientists. I’ve discussed this point too elsewhere on this site, so I’ll just skim over the main points. Because economics is so inexact a “science,” we should not expect it to grant its practitioners deep and accurate economic insight. And experience bears this out. Former Fed Head Bernanke tells us that neither he nor his brethren had any idea that the GFC was coming. This despite the fact that the clues were everywhere. I don’t have a bunch of letters after my name, but I saw the writing on the wall and got out of the markets well before everything went south in 2008.

    In sum, the weapons in the arsenal are not very sophisticated: asset purchases and lowering rates. If a lot of acumen is required to determine when to deploy those weapons, economists apparently do not have it.

    So yes, the sun also sets. We’d like to believe that the Fed can not only pour a never-ending supply of liquor into the punch bowl but wave a magic wand, causing the financial hangover to disappear. However it doesn’t work that way.

    At times like these it is particularly important to remember some old Wall Street wisdom: “Bulls make money. Bears make money. Pigs get slaughtered.” Wall Street can’t just continue to blithely make huge, leveraged, risky bets. No counterparty — not even the Fed — is big enough to fade that kind of action indefinitely. Eventually, a lot of those gamblers are going to be slaughtered.

    But there is a positive side to the old adage. The market is going down? That’s nice. Bears make money too. This might be a good time to work on your list of short sale candidates.

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