Credit Bubble Bulletin, by Doug Noland
Dilly-Dally Monetary Management
December 17, 2004
prudentbear.com
Tuesday the Fed continued its “measured” policy stance by raising rates 25 basis points to 2.25%. Almost universally (or, at least, on Wall Street and with the U.S. media), Mr. Greenspan’s “baby-step” approach is heralded as adept (brilliant?) monetary management. The very utmost caution is taken to ensure that rate increases do not disturb the economy or, more importantly, dispirit the financial markets. I find it ironic that a system that is so trumpeted by Mr. Greenspan for its “resiliency” is treated with such delicate kid gloves.
The Mighty Credit Bubble scoffs at such timidity (and relishing all the pandering to the markets/speculators). The Fed grossly overreacted in 2002. A bursting dollar Bubble, a mushrooming global leveraged speculating community, and the runaway U.S. Mortgage Finance Bubble had already ensured the emergence of abundant liquidity and heightened pricing pressures both at home and abroad. The potential need for helicopter money – I think not. This was followed by the major error of waiting until the past June to nudge rates up from 1%. And now, years of flawed Fed policies are being capped off with the current course of Dilly-Dally Monetary Management. Why would anyone believe that taking the short-term painless course in monetary policy would yield the most beneficial long-term results?
This week provided further evidence that the Fed has not “tightened” at all. And while most would contend that rate increases are “removing accommodation,” such an assertion at this point seems less than accurate. The general financial environment is at least as loose as it has been since the Acute Monetary Disorder of 1999/2000. In many respects – certainly including the Bubbling stock market – the financing environment for business ex-technology has never been as easy. General Credit Availability has not been as easy. Examining some indicators, mortgage Credit growth is currently on record pace; corporate cash flows are booming; the small cap Russell 2000, the Value Line Arithmetic 1650, the S&P 400 Mid-cap, the AMEX Composite, Dow Transports and Utilities, and many financial indices are at all-time highs; M&A activity is approaching tech-Bubble levels; junk bond issuance is at record levels, with Credit spreads at multi-year lows; ABS issuance is at record levels; the securities broker/dealer business is absolutely booming; and it will be a record year in bank Credit growth. Emerging bond spreads have collapsed, with Brazilian bond spreads having narrowed below 400 for the first time since 1997. Evidence abounds that the Greenspan Fed is bringing new meaning to “behind the curve.”
This morning’s inflation report had the year-on-year increase for the CPI at 3.5%. This is the highest reading since May 2001. Year-to-date, the 3.7% rate of consumer price inflation is running even above 2000’s 3.4% rate. It is worth noting that the fed funds rate began 2001 at 6.50%. And last month’s 3.5% y-o-y CPI increase compares to November 2003’s 1.8% (last month's Producer Prices were up 5.0% y-o-y). Moreover, a strong case can be made that the CPI currently understates general inflationary pressures. CPI housing costs were up only 3.1% y-o-y, with “owner’s equivalent rent" up 2.2% over the past year. Meanwhile, medical care increased 4.4% from a year earlier. These do not pass the reasonableness test. It is, furthermore, worth recalling that November Import Prices were up 9.5% y-o-y, with U.S. home prices increasing “at the fastest pace in 25 years” during the third quarter (up 13% y-o-y). Inflationary pressures are strong, rising and broadening, and no amount of denial is going to change reality (although abundant liquidity can admittedly work as one heck of a tonic, for awhile).
I’m going to go out on a limb (ok, a pretty sturdy one) and predict that going forward we will be hearing much less about the Fed having “won the war on inflation.” Similar talk of a convenient (with a low CPI) “inflation targeting” approach to monetary policy will fade, as will wishful notions of the Fed having its work wrapped up at 2.50%. The inflation genie has been let out of its bottle, and historians will likely look back to the bursting of the dollar Bubble as a key inflection point in U.S. and global inflation dynamics. But for now - awash in and intoxicated by liquidity - global Credit market perceptions remain today far behind the inflation curve – echoing the Fed.
While there is no such animal as a single “real inflation rate” in complex contemporary economies (especially with asset inflation, “services” output, and current account deficits providing key outlets for inflationary forces), I would guesstimate a U.S. general consumer price inflation rate for the upcoming year in the range of at least between 4 and 6%. Add another 200 basis points and one might have a short-term rate somewhat less than quite accommodative. Certainly, our base lending rate should today exceed the UK’s (4.75%) and Australia’s (5.25%).
Of course, five percent fed funds would today incite quite a ruckus for our highly leveraged Credit system. The Fed knows as much, and the markets know the Fed knows, and all are afforded the opportunity to prolong Bubbles with the delusion they are acting in the system’s best interest. But the Fed should appreciate that there is today a very high cost associated with Dilly-Dallying. Rates should have been increased before the California (and elsewhere) housing mania took firm hold. After all, once feverish speculative impulses take over and price inflation spikes upward, significantly higher rates are required to temper excess. At that point, the risk of “tempering” inflated asset Bubbles includes a crash. Dilly-Dallying guarantees a Big Crash.
Rates should have been increased before the world fretted the loss of confidence in the dollar. And, importantly, rates should have been raised to quell the speculative impulses of global financial markets, markets commanded by a massive and inflating pool of speculative finance. The U.S. Credit market, “developing” bond and equity markets, global derivatives and now the U.S. stock market have all become acutely speculative and unsound. A strong inflationary/speculative bias has developed for a wide array of assets – real and financial – across the globe. And, again, once such strong impulses take hold they are not easily quashed.
Ten-year Treasury yields are today at about the same level as one year ago (“fundamentals” are not). I would strongly argue that yields have been pressed artificially low by the interplay of global liquidity excess and speculative market dynamics. The bond bears and those hedging against higher rates have faced some ferocious headwinds throughout the year. Repeatedly, market rates appeared to finally commence a decisive move higher, only for “the bears” and hedgers to be forced to scurry for cover (their panic buying forcing prices up and yields down).
Massive foreign central bank purchases and general overly abundant marketplace liquidity has provided a strong inflationary bias for Credit market instruments (U.S. and global). And each bout of sinking yields (marketplace “squeeze”) incited self-reinforcing leveraging by the derivatives (hedging their exposure to lower rates) and speculative players. There are also indications that collapsing Credit spreads provoked a self-reinforcing leveraging of corporate debt instruments, as players on the wrong side of spread trades hedged by taking long positions (a recent Grant’s Interest Rate Observer had an excellent piece on this!). These dynamics (endemic leveraging) yielded only greater liquidity excess and stiffer headwinds for the bond bears.
And, in true speculative dynamics fashion, these bear headwinds incited animal spirits (“squeeze the shorts!”) and downward pressure on yields that simply overpowered fundamentals. Speculative leveraging in Treasuries, agencies, MBS, ABS, corporates, CDOs, CDS (Credit default swaps), and even equities combined for some kind of financial Bubble unlike anything previously experienced. Unprecedented Dollar liquidity – much emanating from securities leveraging - inundated the world! A lot of things changed, many we surely don’t appreciate today.
The bottom line is that the system was in dire need of restraint and received the opposite. To this point, the most conspicuous loser to unrelenting (dollar-denominated) Credit inflation has been the dollar. And the weaker dollar has stoked inflationary pressures at home, while increasing the speculative appeal of non-dollar assets across the globe. Energy and global commodities priced in dollars have experienced major price increases. These price gains and the ultra-easy global financial backdrop have incited a major investment boom – especially throughout the energy sector. The flight to yield and “non-dollars” has afforded “developing” markets extraordinary liquidity. The upshot has been that sectors and economies basically starved of finance for years now have more than they know what to do with (but, rest assured, they will find ways to spend it!) All the while, global inflationary pressures have been building, especially for the U.S. with its faltering currency.
It seemed as if all year long there were expectations that the U.S. and global recovery would falter. There were terror and election jitters. More specifically, there were fears that rising rates and reduced fiscal stimulus would restrain the U.S. consumer, while somehow the Chinese boom-time economy was to come crashing down. Indeed, too often the analysis was slimmed down to the vulnerable U.S. consumer and Chinese investment booms. In reality, the “story” has been much more encompassing and all the while evolving: Not only have the powerful U.S. and Chinese Bubbles proved resilient, the global economy is in the midst of an unprecedented financial boom. The U.S. Credit Bubble has sprouted myriad semi-independent Bubbles across the globe, with strong local currencies accommodating lending and speculative excesses in a manner King Dollar would have never tolerated. The faltering dollar, uncontrolled dollar liquidity creation, and resulting global liquidity and speculative excesses have set in motion inflationary processes that are now increasingly difficult to predict, let alone control. Dilly-Dallying and Global Wildcat Finance are a most dangerous mix.
It is my sense that very powerful global boom and bust dynamics have taken hold the past year, as the Fed Dilly-Dallied fed funds to a paltry 2.25%. The financial world – of unfettered high-powered leveraging, speculating and derivatives – moves these days at lightning speed. Yet the Fed somehow believes it has no alternative than to adjust in s-l-o-w m-o-t-i-o-n. As history has taught us, the cost of falling behind the curve is that only more aggressive monetary restraint is required down the road. This certainly appears to be the way things are progressing at this time, and it will be fascinating to watch how long the bond market can continue to disregard this reality. |
