Excellent Doug Noland analysis of the grim financial outlook once current euphoria peters out.
Second-Term Realities
Vice President Cheney spoke confidently of having won a broad national “mandate,” while President Bush exclaimed, “I earned capital in the campaign, political capital, and now I intend to spend it.” There is no reason to doubt that the Administration will forcefully pursue its ambitious agenda. The President and his team are empowered, with an overarching goal of a second term worthy of an historic legacy. It is, as well, rational that they would today edge toward overconfidence and complacency when it comes to the great risks they will confront during the next four years.
I have no intention to attempt what would surely be amateur political analysis, and I am an analyst and not a partisan. There is no shortage of political insight and pontification these days. Yet I do see a dearth of cogent analysis of the financial, economic and social backdrop that will play a profound role in the political process as we go forward. We witnessed an incredible campaign of “guns and butter” from the opposing parties, heavy on promises and featherweight on economic realities. And now the undoubting victor will attempt to lead a deeply divided nation on an aggressive course in an environment fraught with significant and myriad risks – some discernable.
Never before have financial markets played such a central role in society. More are exposed to marketable securities; more giddily play the mortgage and housing markets; and more have their retirement tied directly to the stock and bond markets. And never before have so many livelihoods been associated with financial and real estate asset prices. The melding of politics to wealth creation – in this case financial wealth - is an innate process, and fanciful notions of an “ownership society” do indeed captivate while in the bosom of an historic asset Bubble. I believe it is reasonable to suggest that had the stock market not recovered, had mortgage rates not dropped to record lows, and had home prices not inflated significantly, the political agenda today would be altogether different. I don’t think one can exaggerate the profound political and social effects of The Great Reflation. And with no intention of being flippant, I do not expect gay marriage to be a major issue in 2008.
In my mind, there is a paramount analytical issue to contemplate: The Bush administration today ardently believes that their policy choices were responsible for what has developed into sustainable economic recovery. And having persevered through a stock market scare, technology collapse, recession, 9/11, Enron and corporate malfeasance, a sinking currency and going to war, there must now be great faith that a much more favorable financial and economic backdrop exists to bless their aggressive agenda. Yet the reality of the environment is not as perceived, and this fact of life will not be efficiently recognized: An historic reflation, inciting “blow-off” Credit Bubble excess, was the dominating feature of the second-half of President Bush’s first term. It is, moreover, at best unsustainable.
It is this evening worth recalling the backdrop that greeted the 2001 inauguration. Fed funds began the year at 6.5%. The late-90s boom had filled the Treasury’s coffer, with talk of a Trillion dollar surplus and a coming shortage of government debt instruments. Gold, at $270, was near a multi-decade low. The CRB commodities index began the year at about 230, down from the 1996 high of about 260 and about where the index stood in 1990 (and significantly below 1980!). Crude oil traded near $27. With Asian, Latin American and other “developing” Credit systems still afflicted with post traumatic stress disorder, liquidity was at a premium for many economies and markets. Global price pressures were generally more forceful to the downside. The dollar index was at about 110, with more than a year remaining of its King Dollar (“blow-off”) run to 120, while the fledgling euro had stumbled badly out of the blocks.
The global appetite for U.S. securities was for all purposes insatiable, with faltering demand for tech stocks instantaneously more than compensated by a newfound lust for (Greenspan) bonds. American financial assets enjoyed a strong inflationary bias when compared to vulnerable global goods, commodities and securities markets. High quality bonds were about to enjoy an historic rally, the speculative instrument of choice for playing the Greenspan Fed’s too-well-telegraphed strategy for responding to the bursting of the equity market Bubble. GSE debt had come into its own as a higher-yielding and highly-liquid near-perfect substitute for Treasuries.
Importantly (and oh so clear in hindsight), the U.S. system in 2001 enjoyed considerable flexibility and capacity to absorb continued Credit and speculative excess without traditional inflationary effects. Indeed, the spectacular “blow-off” throughout the technology sector fogged the analysis that the Credit system and economic Bubbles had room to run. With respect to the real economy – and paralleling global imbalances – some sectors had been starved for finance as liquidity mindlessly inundated tech and telecom.
There was back in 2001 extraordinary capacity for government spending stimulus, while the Fed was heavily armed and poised for historic monetary stimulus. After years of strong expansion, the mortgage finance super-sector was quite well positioned for spectacular excess (waiting only for the next round of reflation, and for homeowners to appreciate that homes, and not stocks, always went up in price). Similar and not unrelated dynamics were in play with respect to the ballooning global “leveraged speculating community.” And with a strong (“King dollar”) bias to own U.S. securities – speculative and otherwise – heightened liquidity (domestic and global) would conveniently rush to purchase Treasuries, agencies, U.S. corporate bonds, MBS and structured products (reminder: “Liquidity Loves Inflation”). This basically gave the U.S. government, Federal Reserve, GSEs, Wall Street and the financial sector, generally, blank checks for which to stimulate and reflate. Especially when the global technology Bubble burst, the Greenspan-commanded U.S. bond market became “the only game in town” for an increasingly powerful speculating community.
With bond vigilantes an extinct species, The Game quickly evolved into a mad dash to leverage the most liquid and inflating asset in the world – U.S. long-term debt instruments – affording absolutely no constraints on over-issuance. Resulting “excess” global dollar liquidity was a misnomer, as it was readily “recycled” right back to profit from The Great Yield Collapse. There was even fancied talk of Argentina and other “developing” economies switching completely to dollar-based monetary regimes.
Many things are less than clear these days, but the stark contrast between the backdrops from 2001 and the soon to commence 2005 should not be one of them. Year-2001 provided the capacity – fiscally and monetarily – for an historic reflation, with a quite atypical global financial and economic backdrop that would prove amazingly accommodative to gross U.S. excess. A strong case can be made as to the aberrational characteristics of the King Dollar period. Importantly, few at home or abroad perceived that there were risks associated with U.S. reflationary policies, and no one protested. Many were keen to the windfall profit opportunities available from financial assets.
These days, oil and energy markets trade at all-time highs, the euro at a record, the dollar index at a multi-year low, gold at a 16-year high, the CRB index not far off all-time highs. Foreign equity and bond markets are outperforming their dollar-denominated counterparts. Most significantly, the U.S. economy and financial markets now face the uncertain and problematic downside of an historic reflation – the mirror image of 2001’s promising upside. The Fed is hopelessly behind the curve, bond yields have overshot on the downside, and equity prices have become distorted to the upside from reliquefication-induced inflated profits and excess marketplace liquidity. Real estate prices are generally over-heated, with California and other upper-end markets demonstrating dangerous Bubble excess. Mortgage finance demonstrates uncomfortable parallels to NASDAQ 1999. And while not yet appreciated, manic over-expansion and excess have destroyed profit opportunities for the bloated U.S. financial sector and leveraged speculating community. The initial light breeze of developing Credit system headwinds has made landfall.
Of more immediate concern, Monetary Disorder is fostering increasingly unstable markets. Commodities markets are increasingly unstable. The bond market succumbed to distortions, speculative excess and, more recently, a short-squeeze and is now vulnerable to a destabilizing jump in rates. And even today’s strong employment data and rate rise could not slow the dollar’s descent. The stock market has lunged higher in a bout of euphoria, hedge unwinding, and short-covering. Extrapolations and daydreams of protracted bull markets are setting the stage for disappointment and worse.
And unlike 2001 or even 2003, there is today a growing list of parties fully cognizant that they are being hurt be inflation. From drivers to homeowners to businesses, energy costs are biting. Housing affordability has become a major issue for millions; the cost and availability of medical care for tens of millions.
Importantly, the weak dollar has become a cause for serious concern. Asian central bankers are rightfully nervous, as surging energy and commodity costs along with unwieldy liquidity create great inflation and economic uncertainty. The ECB is on guard to heightened inflationary pressures, appreciating the risks associated with prolonged energy and commodity price inflation in the event of continued dollar weakness. Expect European political leaders to become increasingly vocal critics of U.S. budget and trade deficits. No longer will our Credit inflation and dollar devaluation go unnoticed or be appreciated. Blather that our massive current account deficits are caused by foreign inflows and the attractiveness of U.S. investment will not go unanswered.
Reiterating analysis from previous Bulletins, history provides some clarity with regard to the nature of inflation cycles: once unleashed, inflation becomes only more difficult to control and there are always hopes that just a little more will suffice. Only more suffices. Few initially recognize the eventual costs, while many clamor and yearn for the perceived benefits. Politicians adore inflation, at least until their constituents learn to abhor it. Over time inflation’s losers become more attentive and the detriment more conspicuous. For society as a whole, the insidious effects of debt and inflation spawn angst, animosity, and polarization. Globally, the redistribution of wealth foments acrimony and conflict.
Today, our administration is understandably ecstatic with the prospect of four more years. And they would surely be content with four additional years of reflation and attendant dollar debasement. But our foreign creditors are being impaired and must be losing patience. Meanwhile, global central bankers are coming to grips with the prospect of ongoing dollar weakness and the associated increasingly unwieldy liquidity and pricing environment. Monetary Disorder has become manifest. And, let’s not forget, the U.S. bond Bubble. It appears that the transition away from the aberrational “weak dollar is good for bonds” period has begun, with unclear but potentially significant consequences. Myriad issues for bond holders now include foreign selling, rising risk and inflation premiums, speculative unwind, derivative-related selling and policymakers much more attune to the needs of the economy and stock market.
Why do I have the sense that it is only a matter of time until the administration’s agenda is placed on the back burner to deal with more pressing issues such as financial and economic instability, or even the dollar’s role as the world’s reserve currency? The scenario I find most troubling is an oblivious policymaking team steadfast in its pursuit of a legacy, stubbornly refusing to accept reality, and in no position or having any inclination to cooperate with our global partners. And it is a tragedy that our nation will face its next crisis so ill-prepared and polarized, and in this regard there is certainly plenty of blame to spread around. |
