I think policy is currently quite accommodative. I think it can remain quite accommodative for a while to come
Delay is the deadliest form of denial
—C. Northcote Parkinson
In More Like A Depression Every Day, I described strong deflationary pressures in the American economy despite the Shock & Awe fiscal & monetary stimulus being applied. The flow of free money is supposed to counter deflation by boosting both asset values and government spending. Economist Nouriel Roubini, otherwise known as "Dr. Doom", notes that this "wall of liquidity" is inflating asset values, not just in the United States, but all over the world.
The BEA's advance estimate showed growth of 3.5% in the third quarter (July-September) just passed. So Shock & Awe appears to be "working" if you go by real GDP. Don't you believe it. I warned you about a "statistical" recovery last week. Get ready for another round of nonsense announcing that the recession is over. In absolute (2005 chained dollars) terms, real GDP is down 9% year-over-year, even after you throw in the "cash-for clunkers" program which gave an artificial boost to personal consumption expenditures.
One important consequence of the Fed keeping interest rates low and its quantitative easing has been a weaker dollar. The world's reserve currency has depreciated 14.6% relative to a basket of other currencies since March 5, 2009 as measured by the U.S. Dollar Index (DXY). The depreciating dollar, combined with the Fed's stated intention to keep interest rates low for an extended period to come, has prompted investors to short the dollar—bet that the value of the dollar will continue to fall. Investors short the dollar via what is called the carry trade (and Figure 1).
Critics focus on the fact that low U.S. interest rates enable investors around the globe to borrow dollars for next to nothing and invest them elsewhere at higher rates.
This bet — known as the dollar carry trade — appears to be one of the forces pushing down value of the dollar. Though there are few reliable figures on the size of the carry trade, the dollar's trend has clearly been down since stock and bond markets revived.
Figure 1 — The Fed has frozen short-term interest rates at 0-0.25% (left) as the dollar declines(right). This allows investors to borrow dollars a little cost and re-invest them in assets that return higher yields.
Roubini believes that continued low interest rates are inflating asset values beyond what the fundamentals dictate all over the world—a new global bubble. He argues that when the Fed finally does raise rates and the dollar strengthens, as it eventually must, there will be another resounding crash in the global economy. Readers here may not be familiar with this kind of material, so I have summarized Roubini's argument as he presented it in this interview with Index Universe and in a guest appearance on CNBC.
- There is a "wall of [excess] liquidity" inflating asset values (in equities, real estate, commodities, credit, gold, in emerging markets) all over the world.
- The Fed has fixed short-term rates at zero (0-0.25%) and is expected to keep them there for the time being. The Fed has also set investor expectations by "controlling and reducing volatility" in the long-term by indicating that they will keep rates low for some time to come.
- Investors borrow at near-zero percent interest rates and get a capital gain by investing elsewhere in assets that yield a higher rate, so "we're in the mother of all carry trades." The carry trade makes the bubble global as investors borrow dollars and invest in foreign assets (for example, in Australian dollars, Brazilian reals, and so on).
- Because the dollar is falling, investors are effectively shorting the dollar and borrowing at negative real interest rates. The carry trade itself results in a dollar sell-off, which causes further weakening. Investors are going long on global assets based on expectations set by the Fed about future interest rates (#2 above).
- The dollar can not keep on falling forever, i.e. the Fed must raise interest rates at some point.
- When the dollar suddenly stops falling and reverses, investors will have to close their dollar shorts, and dump their assets.
- The strengthened dollar will cause a market crash all over the world as assets deflate.
One class of "assets" that is inflating as the dollar depreciates is commodities, including crude oil. (A commodity can viewed as a "hard asset.") The oil price and the dollar's value are inversely correlated, which means that the price of crude rises when the dollar falls. Reuters data shows that this correlation between oil prices and the dollar has reached a coefficient of -0.9 in 2009, .
The dollar had a bad week from October 19-23, so the oil price jumped to over $80/barrel. Then on Monday October 26, the dollar had a "good" day, which caused the oil price to fall back to $78 and change. As of right now, it is , but the longer-term trend is clear.
It is particularly alarming that even relatively small decreases in the Dollar Index (DXY) can cause rather large upward movements in the oil price. The DXY fell from 76.43 on Friday October 9th to its low of 74.92 on Wednesday the 21st, a 2% percent drop. The oil front month contract was selling around $70/barrel during the week October 5-9, but had increased 15% at its highest point last week (Figure 2).
Figure 2 — NYMEX front month closing prices since October, 2008. Note the recent, unwarranted jump. Source.
Roubini discussed crude oil prices together with asset price inflation in the Index Universe interview. I'll quote it at some length because Roubini makes all the important points.
Index Universe — You’ve said that you’re worried we’re already sowing the seeds of the next crisis. Where do you see that most directly?
Roubini — Well, in commodities, I look at oil prices. They fell from $145 last summer, came down to $30 earlier this year and now they’re back close to $80. But if I look at the fundamentals of demand and supply, demand is down to 2005 levels, supply and inventories are at all-time highs. In my view, the movement in oil prices is not fully justified by the fundamentals.
There are improving fundamentals. There is a global recovery. But that justifies oil going from $30 to maybe $50. I think the other $30 is all speculative demand feeding on it—speculators and herding behavior. Last year, when oil was at $145, that killed the global economy. I worry that oil is going to go up above $100 for reasons that have nothing to do with the fundamentals of supply and demand. Oil at $100 would have the same negative effects on the global economy as oil did at $145 last year.
Last year, when oil was at $145, the global economy was still growing. Right now it has collapsed, and is recovering. Oil pushing above $100 would have nasty, negative real trade effects and real disposable-income effects on all importing countries: the U.S, Europe, Japan, China, India; all the countries that were hit by the oil shock last year. So that’s an element that is in my view totally speculative, and dangerous to the global economy.
Index Universe — Is that true elsewhere?
Roubini — I could make a similar argument for other commodity prices. In my view, rising commodity prices are not justified by the fundamentals.
There’s a huge bubble, because we have zero rates in the U.S, zero rates around the world and a huge carry trade. Everyone is borrowing at zero interest rates in dollars and getting a capital gain because the dollar is weakening, so they are borrowing at negative rates. And then they invest in risky assets:commodities, equities, credit. We’re creating a bigger bubble than before [Lehman].
It’s going to go crashing down, in an ugly way. That’s the basics of the argument.
[My note: I'm not sure oil demand is down to 2005 levels, and oil never quite got to $30/barrel, but who can quibble with Roubini?]
I have made many of the same points in several columns, most recently in It's Not Black Or White. Unwarranted oil price inflation is certainly a threat to a global economic recovery in the next year, but another real danger lies in the renewal of systemic risk in global finance, to which I now turn.
A Sense of Foreboding
Gillian Tett of the Financial Times sounded the alarm on October 22, 2009 in Rally fueled by cheap money brings on sense of foreboding (registration/subscription required).
Earlier this month, I received a sobering e-mail from a senior, recently-retired banker. This particular man, a veteran of the credit world, had just chatted with ex-colleagues who are still in the markets – and [he] was feeling deeply shocked.
“Forget about the events of the past 12 months ... the punters are back punting as aggressively as ever,” he wrote. “Highly leveraged short-term trades are back in vogue as players ... jostle to load up on everything from Reits [real estate investment trusts] and commercial property, commodities, emerging markets and regular stocks and bonds.
“Oh, I am sure the banks’ public relations people will talk about the subdued atmosphere in banking, but don’t you believe it,” he continued bitterly, noting that when money is virtually free – or, at least, at 0.5 per cent – traders feel stupid if they don’t leverage up.
“Any sense of control is being chucked out of the window. After the dotcom boom and bust it took a good few years for the market to get its collective mojo back [but] this time it has taken just a few months,” he added. He finished with a despairing question: “Was October 2008 just a dress rehearsal for the crash when this latest bubble bursts?”
I daresay this missive reflects some element of hyperbole. But I have quoted it at length because the question is becoming more critical...
I doubt Roubini would think that Tett's banker friend is exaggerating the problem. I don't think he is. Was October, 2008 just a dress rehearsal for another crash when this latest bubble bursts?
As the the earnest folks at Baseline Scenario never tire of reminding us, we have a financial system here in the United States, in Europe and elsewhere that has not been reformed at all. In fact, it has been bailed out and thus operates regardless of risk. What has changed is that there is a new, enormous free flow of capital for it to gamble with.
This new carry-trade bubble, like all previous ones, encourages reckless behavior. Banks, hedge funds and other investors appear to be leveraging up again like there's no tomorrow—which may be the right strategy for some because there may not be a tomorrow, figuratively speaking.
The Titans of Finance understand that the surest way to re-capitalize themselves and make outrageous short-term profits is to make over-leveraged bets on risky assets just as they did during the Housing Bubble. The Masters of the Universe can count on Central Bank policies which have encouraged this very behavior. (Throw in your favorite conspiracy theory about relationship between the Fed, the Treasury, and the Wall Street Banks here.)
And for Finance, let the consequences be damned. Here is Tett again—
Yet, if you talk at length to traders – or senior bankers – it seems that few truly believe that fundamentals alone explain this [renewed appetite for risk]. Instead, the real trigger is the amount of money that central bankers have poured into the system that is frantically seeking a home, because most banks simply do not want to use that cash to make loans. Hence, the fact that the prices of almost all risk assets are rallying – even as non-risky assets such as Treasuries bounce too.
Now, some western policymakers like to argue – or hope – that this striking rally could be beneficial, in a way, even if it is not initially based on fundamentals. After all, the argument goes, if markets rebound sharply, that should boost animal spirits in a way that could eventually seep through to the “real” economy.
Could eventually seep through to the "real" economy? Boosting animal spirits will magically erase household debt and boost the flow of credit to people who don't want any? How does this work? Pimco's Bill Gross discusses the relationship between inflated asset values and the "real" economy in Midnight Candles. One obvious way in which inflated assets (in stocks, housing) pump up the economy you and I live in is to create phony wealth effects which make us feel rich—bubbles boost our animal spirits!
Stock and home prices went up – then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services..
[My note: See my ASPO-USA conference presentation and related articles. I have covered this ground a number of times.]
In other words, the cart has been placed before the horse. Inflated assets boost spending and GDP, but in a healthy economy, savings & investment in actual production would drive GDP and thus asset values gradually over time.
Gross concludes that in the U.S. alone, assets are overvalued by 15,000,000,000,000 (trillion) dollars as it is (prior to future inflation brought on by Fed policies).
A long history marred only by negative givebacks during recessions in the early 1990s, 2001–2002, and 2008–2009, produced a persistent increase in asset prices vs. nominal GDP that led to an average overall 50-year appreciation advantage of 1.3% annually. That’s another way of saying you would have been far better off investing in paper than factories or machinery or the requisite components of an educated workforce. We, in effect, were hollowing out our productive future at the expense of worthless paper such as subprimes, dotcoms, or in part, blue chip stocks and investment grade/government bonds.
Putting a compounding computer to this 1.3% annual out-performance for 50 years, produces a double, and leads to the conclusion that the return from all assets was 100% (or $15 trillion – one year’s GDP) higher than what it theoretically should have been. Financial leverage, in other words, drove the prices of stocks, bonds, homes, and shopping malls to extraordinary valuation levels – at least compared to 1956 – and there could be payback ahead as the leveraging turns into delevering and nominal GDP growth regains the winner’s platform.
I will return to Gross' analysis in my conclusion.
The bottom-line is that investors are once again trading in paper instead of the production of goods & services (in factories, machinery, public transportation, alternative energy, and so on). The separation of the "real" economy from the Wacky World of Finance in nearly complete. Why bother with the "real" economy if you can make guaranteed money running a casino? Gillian Tett understands what's going on, but hopes she's wrong—
In the meantime, it is crystal clear that the longer that money remains ultra cheap, the more traders will have an incentive to gamble (particularly if they privately suspect that today’s boom will be short-lived and want to score big over the next year). Somehow all this feels horribly familiar; I just hope that my sense of foreboding turns out to be wrong.
Anyone living in the real world knows today's "boom" will be short-lived. Maybe it will all fall apart a year from now, maybe a few quarters earlier, maybe a few quarters later. Who knows what the Central Banks will do? Who knows how high the oil price will go?
What Roubini knows for sure is that the eventually the Fed must raise interest rates and withdraw its quantitative easing. How does he know this? Because if the Fed doesn't ease the throttle back, the U.S. economy and that of the world generally—the dollar is still the world's reserve currency after all— will look like Argentina's in 2002. (I can't do this scenario justice here, so follow the link and do some Google searches.)
Raising interest rates and withdrawing quantitative easing will destroy the "rally" in the S&P 500 if it hasn't blown up already. These steps will end the life-support keeping the U.S. housing market alive, and stop the carry trade fueling a global asset bubble.
It is quite obvious that traders are hoping to "score big" while interest rates remain low. Many of them will take a bath because few will correctly anticipate the timing of events, and not everyone can get out at the top of the bubble. Even small changes in interest rates can set off a wave of defaults, especially in a currency carry trade, if investors are leveraged at 10 to 1, 20 to 1 or more. This is the first rule of Bubbleology.
Once could see this as a reminder that no one in Finance learned anything in the last 10 years. More cynically, we could say that traders know the risks, but the potential rewards are just too tempting to pass up in a world with little economic future. If slow or no real economic growth over the next decade and beyond is not going to cut it, you might as well go for broke. Many banks and hedge funds will go under, but some firms—fewer than there used to be—remain Too-Big-To-Fail.
So I regard any talk about inflated asset values eventually being a boon to the "real" economy as either a self-serving rationalization, an exercise in self-delusion, or an outright lie. Frankly, I don't even know why the Powers-That-Be bother to reassure us little people that things will be OK anymore. But I'll let Joe Saluzzi do the talking.
Joe Saluzzi to Tim Geithner: What planet are you living on?
Returning to Bill Gross—
This 100% overvaluation [of $15 trillion] from recent price peaks of course is crude, simplistic, and unrealistically pessimistic. It implies that stocks should be at – gasp – Dow 7,000 – and that home prices – gasp – should be cut in half from 2007 levels, and that commercial real estate (Las Vegas hotels, big city office buildings that are 20% empty) should likewise face the delevering guillotine. Some of these price adjustments have already taken place...
This is where it gets tricky,
however, because policymakers, (The Fed, the Treasury, the FDIC)
recognize the predicament, maybe not with the same model or in the same
magnitude, but they recognize that asset prices must be
supported in order to generate positive future nominal GDP growth
somewhere close to historical norms. The virus has infected far too
many parts of the economy’s body, for far too long, to go cold turkey...
Gross then goes on theorize the the Fed will likely require 12-18 months of 4%+ nominal growth in GDP before abandoning the 0% short-term benchmark interest rate!
The longer asset prices inflate beyond fundamental levels based on real supply & demand, and the more leveraged-up investors become in those assets, the worse the crash will be when the carry-trade goes belly up. Allow me to repeat from the summary above—
- The dollar can not keep on falling forever, i.e. the Fed must raise interest rates at some point.
- When the dollar suddenly stops falling and reverses, investors will have to close their shorts, and dump their assets.
- The strengthened dollar will cause a market crash all over the world as assets deflate.
When the "carry-trade" bubble collapses, I anticipate a strong round of debt-deflation to take hold in the developed world (OECD) economies — and this next time there will not be a another stimulus fix even if inflation is positive (owing to all the previous stimulus). This latter scenario would mean an extended period of stagflation. Otherwise we will have stag-deflation.
This all goes to show that you can delay, but not prevent, a prolonged severe recession, or if you prefer, Depression. The fundamentals of the "real" economy say there is no real basis for renewed growth. Inflating asset values is politically expedient but merely postpones the inevitable. You must have the recession you need to have—there is no getting around it. As in health care, providing life-support to a doomed patient needlessly raises costs which someone must bear later on. I say pull the plug. Only then can we build a real future.
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