That Kind-Hearted Kate Welling - Part Two

By: Doug Noland | Fri, Apr 1, 2005
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That's pretty strong language.

He's too intelligent to actually believe it. Here's the quote: "Over the past decade, a combination of diverse forces has created a significant increase in the global supply of saving - a global saving glut - which helps explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today." How do you avoid talking about consumption when you're talking about the current account deficit? You don't avoid it accidentally! Bernanke's statement just was not credible coming from someone in his position. Especially at the same time that Japan's prime minister and central bankers throughout Asia are getting a little tired of absorbing these dollar balances. I just think that today our financial officials at least need to demonstrate that we understand there is a problem.

How?

They could start by admitting there are excesses in mortgage finance and beginning to rein it it.

Are you kidding? What a firestorm that would set off.

If they don't address mortgage finance excesses and over-consumption, they'll never address the current account deficit, which is directly linked to them. We're in a liquidity boom now, the banks and the hedge funds have stepped into the roles Fannie and Freddie used to play. But what happens when the market get over-leveraged a little bit and we do not have the GSEs to provide the "backstop" bid? It is going to be so interesting to watch how this works, the next time the hedge funds decide to sell their mortgage-backeds. Who is going to buy them? Obviously, the Fed doesn't want rates to go up to a point that will force the hedge funds to liquidate that paper. But if rates don't go up, we'll add another $1.3 trillion in mortgage credit this year, and add some $750 billion to the current account deficit. Again, what is the end game?

Well, how high can rates go before we hit that tipping point?

No idea. But probably higher than most people think because of financial innovation. If folks don't like the 30-year fixed mortgage rate, they will take the ARM. They just want to get into the home. And that is something, again, that you can see quite clearly in the Z.1.

Where?

In the Household balance sheet, even though it includes "non-profits." During 2004, household assets surged by over 9%, or by $5.07 trillion - meaning that households' assets have grown more in the last two years (by $10.9 trillion) than they did even at the 1998-'99 peak of the tech bubble, when they climbed by $9.4 trillion. And a large chunk of that appreciation took place in the real estate sector. Household real estate holdings climbed by a record $2.21 trillion last year or 12.9% to $18.65 trillion. Household real estate asset values were up 24% in two years and 92% in seven years. Meanwhile, on the liability side of the household ledger, obligations increased 11.7% , or by $1.12 trillion in 2004, and by a stunning $336 billion in the fourth quarter alone, which almost equals the sector's annual average increase in liabilities all through the decade of the 1990s.

So what is the end game?

That has always been the issue with asset inflations throughout history. Back in the 1920s, in my view, the key was the speculative finance that generated excess liquidity. It was mainly leverage created by borrowing to finance securities purchases back then. Mainly stocks. But on the margin it became liquidity for the economy. Then, of course, the asset inflation led to distortions in spending and investing, domestically and globally. When the speculators got hammered and liquidity collapsed, the economy was so distorted that it couldn't function without that speculative liquidity. Today, you can see the spending distortions. You can see also how this speculative liquidity has gone global. A real question is whether today's spending patterns are sustainable domestically. Can we continue to have all this home price inflation to stimulate luxury consumption and everything else? Is consumption sustainable globally? Are all these factories that have been built to send goods to Americans sustainable? If we have problems in mortgage finance and all of a sudden that trillion dollars of mortgage credit drops by half - wow! It would change spending decisions dramatically if home prices started to decline. The system can so easily go from what appears to be just endless amounts of credit and liquidity and spending power to a place where the whole economy is primed for all sorts of spending that just doesn't develop. That's what all the fuss in the tech sector was about. It was all primed for endless liquidity. Because it seemed to have endless liquidity. All the speculative finance was going into technology. Until it reversed. Then technology just collapsed, because everyone had extrapolated the boom times endlessly. Well, now the same dynamic is working globally, through the current account deficit. It will keep working amazingly well, but only as long as the liquidity keeps flowing. And it's not sustainable. That's what isn't generally appreciated about the end of the 1920s and the Depression. Bernanke and Milton Friedman and that whole monetarist crew believes it got out of hand because there was a $4 billion hole in the banking system. They say that the Fed should have just cut a check for $4 billion, recapitalized the banks, and everything would have been wonderful. But it wasn't a $4 billion problem. The asset markets and the whole economy had become so distorted that the Fed could have cut a check for $25 billion every six months back then, and it wouldn't have been enough. It would have taken endless and continuous infusions of huge amounts of liquidity and credit. That's where we are today. It took $1.2 trillion in mortgage credit last year. It will take $1.3 trillion this year. The economy looks like a miracle, but you had better be prepared, because it's not sustainable. That's more than four times the average annual growth in mortgage credit in the 1990s. It's a huge number.

I'm getting the impression you don't think we can just keep adding zeros.

Clearly, the Asian central banks are growing nervous. Maybe they do realize that they had better keep buying dollar assets, because they are going to be buying for a long time. Until the current account deficit declines dramatically, they are going to have to keep buying them. They are going to have to act as buyers of last resort, and buy our paper. But they are becoming nervous about this, and that is an important development.

Why do you say that?

I would argue that for the past 18 months, one of the reasons the dollar decline has been orderly has obviously been that the central banks have acted as the buyers of first and last resort. Everybody knows they will buy. Which is a circumstance that provides a huge advantage for interest rate derivatives players.

How so?

Let's say that a corporation, or a hedge fund, or anyone, goes to JP Morgan and buys dollar protection. What JP Morgan knows is that if they need to short the dollar, they can easily call an Asian central bank and sell them dollars. The whole currency derivatives market has worked seductively well because of its liquidity backstop from Asian central banks. But now there are indications that Asian central banks are not too happy with this arrangement now. At some point, foreign politicians - if not central bankers - will be forced to confront the dollar dilemma. That's one important development that could shake the complacency that has defined this market.

What are some others?

The similar situation in the interest rate market. The GSEs, since 1994, have provided the liquidity backdrop, but the situation is clearly different now. Not only are rates rising and MBS spreads widening, the once high and mighty GSEs are no longer going to be providing the backstop bid. And now we have $50-$60 oil. We have other commodity prices going nuts. We have interest rates that are way too low to rein in these mortgage credit excesses that are becoming very destabilizing because of the current account deficit and over-consumption. So we have all kinds of factors putting pressure on the Fed. The U.S. economy is very strong, and there is a strong inflationary bias, and yet there's been lots and lots of complacency. It could be a very volatile mix. But there is one thing I am sure of, what Dr. Bernanke recently called that "global glut of saving" is actually an historic excess of dollar IOUs. And that these IOUs are predominantly backed by non-productive assets could be a huge problem. That a lot of these IOUs are owned by foreigners only will compound any problems that develop. Worse, an evidently large but unknown portion of these IOUs are held - or hedged - by highly leveraged speculators, which potentially creates what Hyman Minsky called "acute financial fragility."

You see some risks rising. But you said yourself that investors have been very complacent.

They had been lulled to sleep, because of the Fed's interest rate stance, and the enormous backdrop of liquidity. It has seemed that there is free money to be made in things like derivatives. I use the old flood insurance analogy. There has essentially been free money available to write insurance. Nobody has experienced any significant losses in quite some time, so everyone has been willing to write lots of flood insurance. So lots of "insurance" has been written in equities, in currencies, interest rates, especially in the credit default area. After all, writing this insurance produces "free" money. So of course the hedge funds have been very active. Why wouldn't they want to write it and take 20% of the premium every year - until the tail kicks their ass? All of these individual decisions have been very rational. But the whole system has too many players, ensuring that the bubble will continue, until it pops.

And your point is that a lot of individually rational economic acts are adding up to what looks to be a dangerous situation in the market?

We have to say the individual decision is rational, and that's important. This is not a mania in which everyone is running around doing silly things. It's not that. This isn't playing out like other market bubbles we have read about in history books. These decisions are very rational. It is rational for the person out in California to buy a home and to take the adjustable rate mortgage. It's rational for the hedge funds to do what they're doing. It's rational for the businessmen to what they are doing - these are all rational decisions. This credit bubble has nothing to do with rationality. It has to do with the market's pricing mechanism getting distorted. You have such monetary disorder that even though people are making rational decisions, individually, for the system as a whole, those decisions create huge dislocations. I am going to rant forever to make this point. People aren't crazy. The system itself tempts people to do things that are individually very rational, but that, as a whole, can be very dangerous for the system. Very destabilizing. It's all too rational to borrow to buy assets today. It's all too rational to borrow to speculate.

And asset inflation troubles you deeply, even though standard inflation measures aren't even up enough [until recently] to rouse the Fed?

It's everywhere in the world. That's what this is about. It's gone global. It's endemic. It's commodities, home prices, bond prices, stock prices, foreign real estate, emerging bond markets, emerging equity markets, Chinese real estate, for gosh sakes. That's what makes it so inflationary now. You have an environment of rising asset prices and unlimited amounts of cheap liquidity. I mean, good luck! Why would anyone expect the U.S. economy - or the global economy - to slow today with that backdrop? That's the unfolding story. Would a 6% Fed funds rate be crazy? Not that many years ago, we had 6% Fed funds. Certainly inflation is higher today than it was back in 2000. There is an inflation problem. People can deny it all they want. But we're not talking about goods pricing. The pricing of everything made in China or India. We're talking about basically everything else. Medical, housing, energy, college tuition, movie tickets or popcorn, my Milk Duds at the movies on Saturday night. And the problem is global. Even European central bankers are faced with this now. They look at home prices and see that their rates are too low. But they keep them low because of the dollar. It is as if the weak dollar has central bankers all over the world just frozen. They have to keep their rates artificially low, but those low rates, combined with all the excess dollar liquidity is a very potent recipe for asset inflation. That's why I insist that whole problem goes back to credit creation.

And you don't see the air being let out of this massive bubble gently?

It can't happen.

So you've become a cave dweller, or what?

The perennial question. I've argued all along that one thing you don't do is let it go worse. Yet that is exactly what we've done. Just look at what they've allowed to happen out in California, where average home prices are to the moon and all the mortgages are adjustable or interest-only. I believe that there's a case to be made that the fallout from California alone could severely impair the U.S. financial sector.

Wouldn't be the first time.

We should have never allowed mortgage credit to double in seven years. Never. Now we will see annual increases of 12% a year, 13% a year, until the thing blows. As I said, it will take huge amounts of liquidity to sustain these asset markets - whether they trade real estate, bonds, or stocks. So how will the financial sector create that liquidity? Only by continuing to offer interest-only teaser loan rates. We have to lend to the marginal guy who shouldn't be buying a house; to the guy paying double what a reasonable person would pay for a home in San Diego. So we are still sustaining it, but there is going to be a price to be paid.

Well, the Fed has been raising the price of the credit and is about to [did, on Tuesday] raise the price again.

But the Fed isn't controlling or creating the credit. What it is doing is providing the backdrop, in guarantees and promises, that allows people to be comfortable and complacent. But the Fed isn't creating the credit. It is that financial sector that is creating the credit.

There you go again, with your economic heresy.

I can't help that it's not conventional dogma. The analysis works. It is speculative financial activities, in particular, that are creating most of the credit. And that's the danger of it. The Fed doesn't control it. The Fed can control it, when it wants everybody to continue to leverage and to continue to expand credit, as it so effectively encouraged everyone to do in 2002. Trouble is, now speculative finance has gotten so big that it is starting to be destabilizing, and the Fed won't be able to put the genie back in the bottle. At this juncture, the interests of the Fed and the interests of speculators are no longer the same.

As falling long rates, in the face of the Fed's increases in short rates, have been demonstrating?

Sure. Why wouldn't that happen? If you tell everyone exactly what you are going to do, they are going to devise ways to generate speculative gains from that rainbow. You can't tell the speculative marketplace what you're going to do. You're just asking for trouble.

Transparency is not always and everywhere wonderful?

The system does not function well when you have out of control speculative access. In a normal climate, they can and should be transparent. But not today. Speculators need to be punished today so that they don't go out and continue to do the things that are destabilizing for the system. But the Fed obviously can't do that today because the whole system has been rendered fragile by its reliance on hugely leveraged underpinnings. Which means, in effect, that the Fed has lost its power to control speculative finance. Its baby steps are ridiculous. They are not going to do anything.

Except, maybe, change psychology slowly?

Again, the speculation has gone global. Today, the money wants to go everywhere - or, rather, the finance wants to go everywhere. It will play Brazil, China, India, emerging market. It is taking enormous amounts of liquidity to keep these markets all levitated. Now, the system can create enough credit, but these amounts are so huge that this is going to be much more destabilizing than what most would expect. That's why we could easily see $60-$70-$80 oil. Things can get crazy now because liquidity has just taken on a life of its own.

Has oil taken gold's place as a store of value?

Not really. But gold still has the issue of the central banks' inventories of gold, and how much they are selling. So there are still supply issues in gold. But clearly, financial players around the world are now saying, "I will trade some of my dollar balances for crude because I need the crude." The Chinese are clearly going to buy oil and any commodity they can trade their dollar balances for, without causing too big of a crisis. Why wouldn't they? These are smart people. They don't need the dollar balances. They buy them because someone has to buy them. At any opportunity to trade them for copper or zinc or anything, they will trade. Everyone wants to act as if the global environment never changes. The reality is that it has changed profoundly, in just a few years. What I am contending today is that the period of "disinflation" has ended - ironically, just when some have been trumpeting that the Fed has won the battle against inflation. We have very highly liquid competitors now. And we are bidding against them for whatever we want or need. Meanwhile, the foreign credit systems that used to be highly constrained by the strong dollar - by the fear that if they did anything risky, speculative financial flows would desert them for the safety of the U.S. - have been utterly unleashed. Now, it's like everyone has a checkbook backed with U.S. dollars and can do whatever they want. There is no restraint on any credit system now. Be it China, India, or Brazil, these countries can create all this credit and finance domestic booms without having to worry about a run on their currencies. They can inflate for awhile, and that will ease their transitions into a flexible currency system. Again, in the weak dollar now - the dollar's vulnerability - gives credit systems around the world almost a hall pass to do things that they weren't able to do five years ago or even three years ago. They're no longer worried about a currency collapse throughout Asia. They are worried about the currencies melting up. This is an inflationary bias that many analysts have missed. And you see it in Latin America today, too. These are very, very important developments. Maybe financial speculation will keep all these markets levitated. I'm not saying that can't happen. But if it does, we're going to see wild price movements, shortages of all sorts of things, and things will get very strange.

You see no other alternatives?

Well, baby steps by the Fed in this environment are not going to cut it. But if something occurs to make the spread traders and the leverage players reevaluate how high market rates can go, that could produce a major market event. I don't know what that could be, given this liquidity backdrop. However, if liquidity starts to go the other way and bond yields rise and all of a sudden everyone wakes up and smells inflation, there could be a very profound change in market psychology.

And Nirvana for bears?

I can dream, can't I?

Postscript: Post Tuesday's Rate Hike

The markets initial reactions say the Fed has caught someone's attention this time, Doug -

So it would seem. The bond market, in particular, has been gliding along on the assumption that the carry trade, et al, were safe because of the latest version of the Greenspan put: It's his last year, in office, so the great one isn't going to let anything happen. He understands how leveraged the system is, understands all the fragilities. It's as if they've been singing, "Don't Rock The Boat, Baby" to him, and he's been dancing along.

But now, suddenly, it looks like he might?

The thing is, if someone steps back and considers it dispassionately, the Greenspan Fed has been anything but infallible. They appear in hindsight to have been totally oblivious to LTCM, they totally misplayed Y2K - I could go on and on. So maybe some bond market players have started to realize they've been giving the Fed too much credit. Maybe they've started wondering, finally, if the Fed does really look at the world conventionally and so may have decided that rates need to go to 5% or even higher. If so, we may be seeing the beginning of a market reality check. "Maybe we don't have the Fed in our back pocket and maybe they're really worried about inflation." If so, this is a very dangerous change in perceptions in the bond market, because it was well beyond the point where fundamentals didn't matter. Anytime you get a market where fundamentals don't matter, you're heading down a slippery slope. And it could be that the bond market is starting to pay a price for that now.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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