Tightening Lite?
The Credit-induced “reflationary” boom and attendant inflationary forces (building for months) have finally captured the attention of the bond market. Apparently, the bond market now cares because it assumes the Fed cares. How much the Fed “cares,” at this juncture, is unclear. There is still no sign that a rate increase is imminent, with Fed officials seeming to signal this week that they would like to remain patient. I have no doubt they hope to remain patient.
And it has quickly become popular to compare the current environment to 1994. Certainly, there are meaningful similarities. Most notably, the Fed was in early 1994 significantly “behind the curve.” Artificially low short-term rates and a steep yield curve had induced enormous leveraged speculation. Furthermore, Credit market excesses were increasingly fueling unbalanced growth and heightened pricing pressures both at home and abroad.
As market analysts, however, there are some major differences between today and the waning days of the previous environment of prolonged monetary laxity. First of all, the degree of current excess is so beyond 1994 that it is difficult to draw reasonable comparisons. The hedge fund community is likely approaching 10 to 15 times the size of 1994. Wall Street proprietary trading positions have ballooned as well (Broker/Dealer assets are up 350% since the end of 1994). GSE assets have ballooned from about $630 billion to begin 1994, to recently surpass $2.8 Trillion. Government security dealer “repo” positions have surged from $766 billion to a recent high of $2.75 Trillion. There is, as well, the explosion of derivative positions since the fledgling days of derivative trading back in the early nineties. And while the frantic excesses of 1993 created liquidity to fuel a Bubble in Mexico (and, to a lesser extent, Latin America), today’s unprecedented liquidity excesses feed myriad Bubbles around the globe.
Systemic risk is today much, much greater than 1994 – domestically and for degenerate global financial systems and maladjusted economies. Importantly, the Fed recognizes as much. The Fed may have been naïve to the growing influence that leveraged speculation and derivative trading were playing in the marketplace back in 1994. Yet they are today exceedingly keen. We are forced to shape our analysis accordingly.
The Fed today faces a massive and endemic U.S. Credit Bubble unlike anything that existed during 1994. Worse yet, it’s gone global. While there were some excesses building, the environment from 10 years ago in few ways resembled today’s dangerously distorted U.S. Bubble economy. Our economy has basically suffered from more than a decade of cumulative monetary disorder. We ran a trade deficit of about $21 billion during the first quarter of 1994, something we accomplish these days in a couple weeks or so. The dollar was certainly on much more stable footing to begin the ’94 tightening cycle. Foreign dollar holdings were a fraction of what they are today.
It is also worth noting that Household Mortgage Debt (HMD) increased $183.5 billion during 1994 (5.8% growth rate), with three-year (‘92-94) expansion of $515.5 billion (18%). In comparison, HMD surged $820 billion during 2003 (12.7% growth rate), with a three-year increase of almost $2.1 Trillion (40%). There was no Mortgage Finance Bubble back during 1994, and there were no California or East Coast housing Bubbles. Prior to the Fed raising rates a decade ago, there had been no major surge in adjustable-rate mortgages. Interest-only mortgages and 100% financing options were considered reckless. Twenty percent down-payments were commonplace, especially for GSE “conventional” loans. Down-payment “assistance” programs had yet to be contemplated.
Thus, it is reasonable to assume that the Fed will approach this rate-tightening cycle with extreme caution – extra-soft kid gloves and ultra-baby steps. They will surely err on the side of waiting and watching. And when they do move, I would not be surprised if the Fed attempts to signal to the markets their intention of implementing some type of a cap on how high the Fed intends to move rates. Extraordinary effort will be taken to avoid the 1994 dilemma where the de-leveraging bond market was forcing the Fed’s hand – each rate hike had the marketplace seemingly discounting only more tightening and the Fed, perceivably, always lagging the markets. Governor Bernanke and others would today love to implement an “inflation targeting” monetary mechanism that would allow the Fed to signal the need to increase rates – in the context of the current inflation rate – perhaps in the range of 2% to 2.5%. I expect the Fed to go to extraordinary measures to appease the leverage players, with the specific purpose of avoiding a 1994-style de-leveraging. The Fed’s goal will be Tightening Lite.
The problem is that Tightening Lite is just not going to cut it. There are historic financial excesses and economic distortions that require tough medicine. Gradualism from the Fed will only prolong this most dangerous “terminal” phase of Credit Bubble excess. Curiously, I have yet to hear much talk of the Fed orchestrating the storied “soft landing.” Well, I would argue that gradualism, in the face of current domestic and global financial and economic maladjustment, equates with an only more problematic hard landing. And the clock is ticking rapidly.
I would today argue that the two key issues are extreme Credit Availability and Bubble Dynamics, and both are likely immune to a few “baby steps” from the Fed. Granted, the entire U.S. Credit system is vulnerable to de-leveraging and dislocation. And all bets are off if market rates surge significantly higher from here. But we should remain mindful of the power of Bubble dynamics and the extraordinary institutional and governmental support for boom perpetuation.
We can, as well, look to the economies and housing markets in England and Australia for evidence as to the resiliency of Bubbles to moderate interest rate increases. If Credit is easily available, somewhat higher rates will not dissuade eager borrowers – especially when borrowing to acquire rapidly appreciating assets!
I expect that rates will need to move considerably higher here in the U.S. to dampen what has evolved to manic enthusiasm for real estate, especially out in California and all along the East Coast. It is worth recalling that the Fed raised rates 25 basis points to 5.0% in June 1999. The Fed came back with 25 basis points more in August and another 25 in November. In February 2000, the Fed hiked rates 25 basis points more to 5.75%, then raised another 25 the next month. In the process of the Fed hiking rates 125 basis points over about nine months (to 6%), the NASDAQ100 more than doubled. Bubble dynamics are powerful, and this is specifically why it is imperative for central banks to be vigilant. They must be on guard and determined to quash Bubbles early, and they must be resolved to avoid “falling behind the curve.” Our Fed has failed miserably on both counts, and there will be a high cost to pay.
I certainly don’t see this week’s 3.67% one-year adjustable rate out in the West discouraging prospective California home buyers. And, for now, I would be surprised to see any meaningful moderation in overall mortgage debt growth. As such, I will err on the side of expecting the current consumption boom/Bubble to run hot for a bit. If this proves to be the case, massive trade deficits will be unrelenting, foreign central bank dollar purchases will be necessarily unrelenting, global liquidity excesses will prevail, and this unsound global inflationary boom will survive to create only more precarious financial and economic fragility.
And an over-liquefied global financial system – if sustained – would continue to provide a powerful counterbalance to Chinese authorities’ efforts to rein in their historic boom. Again, Bubble dynamics are powerful and we are in the midst of a global Credit Bubble unlike anything previously experienced. It is no coincidence that the historic American and Chinese booms run concurrently, a dynamic that will now further complicate and already complex dilemma for respective monetary authorities.
There is a view today that the hedge funds have fueled Bubbles throughout various commodity markets, leaving commodities especially vulnerable to a major bust in the event of tightening global liquidity conditions. Such thinking may certainly have merit. However, I recall (and was sympathetic to) similar analysis going back a decade to when the hedge funds were taking large leveraged positions in the bond market. Well, speculators became only more enamored with bonds each passing year.
My hunch is that speculative interest, having returned to commodities after a long hiatus, will not prove a flash in the pan. And, importantly, the size of the global pool of speculative finance has absolutely mushroomed over the past decade. I expect many commodities will only become more enticing over time, as the dollar and currencies devalue and financial asset prices decline. At the same time, I fully expect that wild volatility is here to stay – Markets Governed by The Law of the Jungle. And unpredictable price behavior should only continue to encourage end-users to stock larger inventories and hedge exposures. Market psychology has been altered; inflation psychology has taken hold and speculative dynamics are only one aspect of this fascinating development. I would expect Tightening Lite to be constructive for commodities.
But how about the dollar? Higher rates would surely help support our vulnerable currency. Yet it is my view that what really weighs on the dollar’s intermediate and long-term prospects is the massive inflation of non-productive dollar claims and the attendant liquidity that flows incessantly abroad. And I am essentially to the point where I will assume that nothing short of financial crisis will interrupt this inflation. Sure, currency markets will be prone to violent moves and the type of erratic ebb and flow associated with indecision and aggressive speculative trading. Especially with the massive amount of hedging taking place these days, we should not be surprised if these “ebbs and flows” are at time astonishing.
I could be wrong on all this. Perhaps the Fed can succeed in tempering Credit and speculative excess just enough without precipitating the bursting of myriad Bubbles (bond market, equities, mortgage finance, housing construction, general economy, etc.). I just don’t see how it’s possible. And I fully expect the Fed to err on the side of caution – Tightening Lite. Yet Tightening Lite is not tightening at all. Rather, it is really only more of the same – easy money and the wholesale acquiescence of lending excess, leveraging, asset inflation and endemic financial speculation. Being so far behind the curve and staring unprecedented risk eye-to-eye, it’s going to take some real guts and determination to rein things in. I’ll believe it when I see it.
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