Doug Noland:
A normal cyclical recovery would experience burgeoning demand throughout the interest rate sensitive sectors, particularly housing and autos. Pent-up demand (especially for durables) would hold the key to accelerating growth. Additionally, a surge in capital spending would be expected to play an instrumental role in propelling the fledgling expansion. And, importantly, unfolding recovery would be stoked by easing Credit conditions, with lenders loosening Credit availability after an extended period of caution. Logical and historically relevant yes, but all of this has virtually nothing to do with today’s financial and economic landscape.
Indeed, there’s little normal about the current environment. It’s categorically abnormal and it’s surely not a “recovery.” Rate sensitive sectors have enjoyed booming demand for several years now – powering into overdrive since the Fed began cutting rates aggressively back in late 2000. Capital spending is playing a trivial at best role in the current expansion, as we continue to gut our nation’s manufacturing base. And instead of a cyclical easing of Credit conditions and a resulting up-tick in borrowings, we are witnessing a blow-off surge after years of unprecedented excess. Rather than a typical cyclical housing recovery, we are witnessing very late stage parabolic excess and (financial and economic) distortion.
There are two fundamental aspects of Credit-induced booms that are today very much in play. First, for the real economy, Credit excess begets only greater excess. The more Credit excesses stoke spending and economic “output,” the greater will be the demand for additional borrowings. Credit inflation begets self-reinforcing inflation of varying manifestations. This is the very essence of Credit booms, and once heated up they become only increasingly unwieldy. Ours has turned white-hot.
Conspicuously, the monetary/services U.S. (maladjusted) economy is being driven by extreme Credit excess (household, federal, financial, and state and local borrowings). And while some hold the view that today’s “recovery” is weak and unsustainable, Credit Bubble analysis would approach this debate differently: as long as financial market liquidity and the current ultra-easy Credit environment are sustained, the economy is likely to surprise on the upside. In the process things become only more “unwieldy,” as we have been witnessing of late. This is why I incessantly argue that a stable and manageable Credit system should be central bankers’ top priority. The Fed ignores the issue completely.
The second fundamental aspect of Credit booms is the critical role played by self-reinforcing asset inflation. Credit excess begets rising asset prices that beget additional borrowing demands and higher asset prices. Overheated Credit systems and rising asset prices create their own liquidity, fomenting seductive Bubble market dynamics. This is why contemporary central bankers must recognize and guard against asset Bubbles (also a top priority). The Fed ignores the issue completely.
Inarguably, the contemporary U.S. Bubble economy is married to inflating real estate prices and inflating securities values (expanding quantities, as well as rising prices) like never before. The “good” news is that a strong inflationary bias is maintained throughout mortgage finance, the Credit system generally, and the "services" real economy. Current inflationary momentum likely dictates that there is some time remaining for the overheated national housing market, as well as a bit more life left for many dangerous housing Bubbles, including California. But we are in the dangerous, very late stages of an historic housing boom and mortgage finance Bubble. One percent Fed funds is grossly inappropriate for this stage of the Credit cycle.
Importantly, there is today The Great Misinterpretation: Most see Promising Nascent Recovery when the reality is Precarious Late Stage Credit Boom. And while I may concur with the optimists regarding near-term GDP acceleration, that’s the extent of our “meeting of the minds.” They relish in the perceived opportunities afforded by cyclical upturns, giddy with the belief that we’ve seen the worst (and it really wasn’t half bad). We see a very different world: the perpetuation of Bubble excess, inducing a compounding of serious mistakes that occur at the manic final stage of the cycle.
First of all, considering the fundamental backdrop, current stock market sentiment is truly extraordinary. (Over) Liquidity has worked its seductive magic, with investor optimism having returned to extreme levels. The hedge funds have been forced to reduce short positions, derivative players have unwound bearish trades, and money is again aggressively chasing performance. All of this sets the stage for yet another round of disappointment. And, as always, the “news” follows the general direction of stock prices. Good news is today accentuated (i.e. Intel’s announcement), while negative developments are downplayed or completely ignored. When stock prices commence their decline, we will be hearing and reading much more about the unfolding quagmire in Iraq (as well as Afghanistan and the faltering Mid-East peace process) and the festering energy crisis. There are some serious unfolding problems that are today being whitewashed.
And when it comes to Late Cycle Errors, the Fed is absolutely making a mockery out of sound central banking. The economy is quickly heading toward 4% growth, there’s double-digit mortgage debt expansion and a buyers’ panic in some key housing markets, energy (and other) prices are surging, general Credit conditions could not be easier, and our trade deficits are out of control. Meanwhile, this week saw a parade of central bankers assuring the markets that they would keep rates at 1% for “a considerable time”. As such, the Fed is committing (one more) huge mistake. They are playing this as Accommodating Nascent Recovery, when they should be Clamping Down on Late Stage Unruly Credit Boom. In the process, our central bank is bringing new meaning to the term “Behind the Curve.” The Credit market has much reason to worry.
Curiously, amid this week’s stock market euphoria, the financial stocks quietly traded unimpressively. Apparently our central bankers believe they are doing the bond market another favor by promising not to raise rates. Yet, so aggressively accommodating Post-boom Boom is doing only further disservice to financial stability. If this were Nascent Recovery fueled by capital investment and pent-up demand for durables, moderate Fed accommodation would be appropriate. To maintain unprecedented accommodation in today’s Late Stage Bubble Environment is reckless.
Today’s dilemma – our system’s Achilles heel – is that the financial sector has no alternative than to aggressively expand holdings of risky assets (securities and mortgages). The Fed is on a futile crusade to sustain an unsustainable Bubble that must be financed by a ballooning financial system. There is simply no way around this fact of life. This brings us to the issue of Fed credibility. To read and listen to what our central bankers are thinking these days is not comforting (ok, it’s disturbing). They simply could not be more lost in flawed analysis and oblivious to critical issues. It certainly appears to me that the Greenspan Fed is today the proverbial deer caught in the headlights. I would expect this to be a seething issue for the vulnerable bond market over the coming weeks. As always, the risk of being Behind the Curve is that, after waiting too long, more drastic measures are necessary to get things under control. While comfortable that they have the Fed in their back pocket, the Credit market will nonetheless be haunted by nightmares of an unchecked Credit boom and an endless flood of risky loans and securities. |
