Nobody Can Stop This Runaway Train
by Marshall Auerback
April 13, 2004
In spite of the persistent refusal of Mr Greenspan to recognise it as such, a number of us identified the late 1990’s high tech stock market for what it was - a bubble. When the bubble began to burst, it still wasn’t clear to most market participants that it was a bubble. But with the NASDAQ still down more than 60 per cent from its peak, NASDAQ stocks still at unprecedented pre bubble valuations, and the integrity of the earnings of this sector in question, it is now generally conceded by most (even the Fed) that a bubble did indeed exist.
The fallout from this high tech collapse has been much less according to form. Based on the experience of other asset bubble collapses, history suggested that the bursting of this bubble would generate a hard landing. It did in the corporate high tech sector globally. But, with the amazing debt fuelled 6 per cent annualised rate of take off in real US consumer spending in Q4 2001, and the stunning follow through for the past 2 years (culminating in today’s stunning March retail sales figure, the biggest increase in a year), it appears that the US consumer has weathered the fall in stock prices -but only thanks to the generation of a series of other mini-bubbles, all symptomatic of a broader credit bubble..
We confess to have been taken by surprise by this credit induced expenditure. Many acknowledge that it now sets the economy on a path of even higher private debt relative to income – a path that is (correctly, in our view) deemed not to be sustainable. The debate now is about the timing of the presumed inevitable end to this private credit bubble. And as the debate has intensified, so too have the warnings from abroad.
The latest salvo comes from the International Monetary Fund, in their recent “Global Financial Stability Report”. In it, we find themes regarding the risk of asset bubbles in a low fed funds rate environment, the use of excess leverage in overly crowded trades, and the difficulty of executing a smooth exit strategy from this condition. These themes should sound familiar to readers of this web site. The IMF is remarkably clear headed about the precipitating conditions and propagating mechanisms of financial stability from the current macro/market set up:
“Low short term interest rates and a steep yield curve provide powerful incentives to boost leverage, undertake carry trades, and seek yield by going out along the credit risk spectrum. There is a real risk of investor complacency in a low interest rate environment. An unanticipated spike in yields and volatility in the US treasury market could also trigger a widening of credit spreads in mature and emerging markets and encourage an unwinding of carry trades and leveraged positions.
In this environment, policymakers and regulators must be vigilant for excessively leveraged or concentrated investor positions.”
Who do you think the IMF has in mind here? While acknowledging that “the withdrawal of monetary stimulus could trigger a widespread reassessment of asset valuations”, and conceding that the move toward monetary tightening must be “carefully managed and clearly communicated to the markets”, there is an implicit rebuke to those on the Fed, who persist in giving a green light to hedge speculation by indicating a huge reluctance to raise interest rates imminently. In spite of the removal of the assurance on January 28 that interest rates would remain low “for a considerable period”, the Fed has continually made it clear from the top down that they once again do not perceive bubbles as having been formed, and also have concluded that even in the event of a policy-induced bubble they feel confident in their ability to control the fallout. Kohn's recent speech was directly targeted at Steve Roach and their other critics on this front; he went through every area and more or less said, “Bubble? What bubble? No bubble here!”
The real enabler has been Chairman Greenspan himself, of course. Rather than issue mea culpas for having been present at the creation of the biggest stock-market bubble in modern times, maybe all time, he has focused his commentary over the past year on what a marvellous job the Fed has done in responding to the bubble, which in any case by his lights they never could have recognised or dealt with in advance. It is this extraordinary complacency, or hubris in Mr Greenspan’s case, which ultimately sets the stage for the coming debacle, which the IMF and others have continued to sound the alarm about.
At the most recent Fed Monetary Policy Committee meeting, even the soon-to-retire “inflation hawk”, Robert Parry, wanted a half-point reduction in the Fed funds rate because he was worried about what appeared to be a faltering economy, according to a recent Washington Post piece by columnist John Barry, long considered to be a Fed mouthpiece. In addition to these comments from the "inflation hawk", last week St. Louis Federal Reserve President William Poole made the following remarks:
``There is no regular and reliable relationship between inflation in materials prices or goods at an early stage of processing and retail price inflation,' said Poole, who is a voting member of the Federal Open Market Committee, which sets interest rates. ``We do not want to respond to inflation noise, which would add further instability to the economy.'
As market commentator, Jim Bianco, wryly noted: “The ‘inflation hawk’ wants to cut rates again and the Fed is arguing that commodity prices have little to do with inflation.” Bianco has helpfully collated a random sampling indicating something to the contrary:
· The Wall Street Journal - Price Increases in Asia Fan Inflation Fears in U.S. As Production Costs Rise, Imports Could Get Pricier; Fed Not Eager to Boost Rates
Sharp increases in global commodity prices are beginning to push consumer prices higher in Asia, boosting the odds that inflation will be exported to the U.S. and elsewhere in the months ahead. Consumer prices had been holding fairly steady, or even declining, in much of Asia in recent years, as the region's economies worked off excess capacity amid the global downturn. But as Asia heats up again, price pressures are building, in large part because of China's ravenous appetite for raw materials. Oil prices have shot up and are hovering around $35 a barrel, while the prices of other raw materials, including scrap steel and copper, are double or more what they were just 18 months ago. As a result, consumer price inflation, while still extremely low in Asia by historical standards, has accelerated in recent months. The most significant turnaround has occurred in China. That country's inflation rate, though easing slightly in February, has jumped in recent months, including a 3.2% surge in January, compared with the year before. That comes after prices were nearly flat or declining through much of 2002 and 2003.
· The New York Times - Prices for Plywood, and Its Alternative, Keep Pushing Higher
Lumber and plywood prices have shot up so rapidly in recent months that they are tearing the profit out of home construction for some builders and threatening to dent the booming housing market.
· Associated Press - Soaring steel prices may cost consumers
Soaring steel prices, a boon to a troubled U.S. industry, also have a downside: American consumers eventually will pay more for automobiles, refrigerators and even roller coaster rides. Analysts and other industries say it's just a matter of time.
· The Kansas City Star - Soybean prices hit consumers
Soybean prices, which have climbed to levels not seen in 15 years, renewed their upward trend Wednesday, and consumers are starting to feel the effect. A recent check by the American Farm Bureau Federation found that out of 16 basic food items surveyed, vegetable oil gained the most in price in the first quarter of 2004 over the fourth quarter of 2003. The nationwide survey found vegetable oil had increased 48 cents to $2.76 for a 32-ounce bottle in the first quarter of 2004.
We cite these examples to illustrate that something is clearly giving way: pressure is building for the Fed to remove its overly accommodative monetary stance - despite the open recognition and admission by them that there is no easy way to back out of the credit morass they have created and nurtured over the past decade.
The risk, of course, is having read this report or seen references to it in the financial media, the leveraged speculating community may begin to try to hasten the arrival of some of these risks by betting the Fed has no easy way out, starting with a bet on a “spike in yields and volatility in the US Treasury market" which "could also trigger a widening of credit spreads”, as the IMF document suggests. If in fact aggressive professional investors do anticipate such repercussions, and begin to put on trades to benefit from them, they will have a good chance of initiating a self-fulfilling prophecy which would place the Fed in even more of a policy pickle. Such policy dilemmas, after all, can be the means to make a killing, as George Soros illustrated when he took on the Bank of England in 1992 in its sterling defence.
But they can also be the means to further huge financial disruptions, as any Asian policymaker around during the late 1990s can attest. Thus far in the US, credit expansion has proven so virile over the past two years that if the dynamics of the recent economic recovery become cumulative or self reinforcing, it may persist through a multi year expansion and the ultimate fallout could be much worse.
What are the driving factors here? For one thing, the recovery of house prices in the US since the days of “recession” in 2001 has metamorphosed into a fully-fledged real estate bubble. The re-establishment of a positive trend in equity prices has set into motion once again the full dynamics of rational destabilising speculation, except that, this time around, participants (as Leon Cooperman recently illustrated) no longer believe in the fantasies of new era never ending growth and profit miracles but are playing along cynically only because the Fed has orchestrated everyone else to do so.
Cynically gaming a self fulfilling prophesy is surely a difficult and dangerous exercise. As for the US balance-of-payments and current account with the rest of the world, in such an environment Goldman Sachs’ chief global economist Jim O’Neill has simulated a likely outcome with US external debt, now at a hefty 25 per cent of GDP, rising into the 40 per cent – 50 per cent range - a level that is characteristic of LDC debt delinquents.
But how can the current dynamic be halted? How, for example, does one stand in the way of a housing bubble mischaracterised by Franklin Raines, as a “piece of the American dream”, even though the explosive growth in mortgage finance has, as our colleague Doug Noland has vividly demonstrated, become a hugely destabilising part of the American financial landscape? In this case, the ultimate investor purchases an instrument which he believes to be government guaranteed; consequently, the entire private credit risk is believed to be socialised through GSE intermediation or insurance. For all of the tough talk now meted out by Treasury Secretary Snow, or various members of Congress, when the crunch comes, will the government truly withdraw this implicit guarantee?
In fact, it is almost nonsensical to speak of a “credit system” in the US any longer, since the use of the term “system” implies that there is some underlying systemic structure, ultimately controlled by a responsible regulating entity, such as a central bank. As Doug Noland has illustrated time and again, this is a completely fictional construct: the whole US system today works toward credit “dis-intermediation”, rendering some form of external constraint virtually impossible. Asset backed securities, convertible bonds, financial commercial paper, structured finance, the proprietary desks of the commercial banks, and the hedge funds all slice and dice credit out of any recognisable form: we see nothing more than acts of financial engineering, which eventually drive a wedge between the ultimate borrower and the ultimate lender.
Similarly, the use of derivatives, particularly those of the OTC variety, are of such complexity and opacity, that it is virtually impossible for the market to exert any kind of discipline, since most do not understand the nature of the credit or the complexity of the risk being held in the portfolio, thereby engendering mis-pricing in the risk premiums. By the same token, for regulators to understand and thereby deter a huge potential source of destabilising financial speculation (assuming, of course, that they want to deter, which is questionable in the case of the Fed), they need to have some understanding of the underlying instruments which are the source of so much financial destabilisation. But in most instances, the authorities seem reluctant or unable to tackle the problem (as the examples of Enron and Parmalat vividly illustrate) until disaster strikes. So it is absurd (for the Fed in particular) to laud the use of derivatives as (in the words of Mr Greenspan) “more calibrated than before to not only reward innovation but also to discipline the mistakes of private investment or public policy”, when neither the market participants, nor the regulators, can properly calibrate the risks involved.
For all of the warnings of the IMF, it is clear that in today’s environment, both the Fed, and the leveraged speculating community whose interests it persistently champions, may have more instruments to keep the credit spigot open than most of us realise. This is why the rise in commodity prices has been so telling: something is finally cracking in the system in spite of persistent denials of its relevance. Whether this is occurring because of the increased activities of leveraged hedge funds or a surge in genuine end-user demand is almost beside the point because both are two sides of the same coin: global liquidity run amok. China is the prime example now, as this where some of the consequences of the US policy strategy are being felt owing in part to the dollar/RMB peg. The unsustainable boom in productive capacity creation there (and the corresponding parabolic rise in commodity prices) can be traced back to the Fed-induced borrowing and spending boom over here, and the rock-bottom financing rates for risky ventures enabled by the sharply positive yield curve, precisely the sort of issues touched on by the IMF report. But no amount of warning, however well intentioned, is going to stop this runaway train until the wreck inevitably occurs. |
