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Fed Balance Sheet vs. Stock Market; Will QE Cause Inflation? US in a Minsky Bubble? About to Go Japanese? Looming Credit Crunch?
In response to Japan Near Stagnation Following 9 Months of Growth; Service Sector Prices Back in Deflation; Spotlight on Abenomics My friend "BC" writes ...
With little or no bank lending growth, decelerating wage growth, and trend growth of real GDP per capita at 0% to negative implies the 3- and 5-year change rates of US M2+ will decelerate from 2-3% to 0-1% in the next 5-6 years as occurred during the early to late '00s in Japan.
We're not turning Japanese because we want to, and we have convinced ourselves that we won't, even though the too-big-to-fail banks and Fed are responding in precisely the manner one would expect as we, in fact, turn increasingly Japanese.
The S&P 500 is ~200% overvalued in this context in a classic "Minsky Bubble".
Fed Balance Sheet vs. Stock Market
The above chart from reader Tim Wallace.
US in a Minsky Bubble?
John Hussman had a thought-provoking article this week on the The Minsky Bubble
What's fascinating about QE is that it has no transmission mechanism to the real economy except as a weak can-kicking exercise - and even then only by creating enormous distortions in pursuit of minute "wealth effects." The risk premiums of risky securities have become unsustainably compressed in the process, and the Fed's balance sheet has metastasized to $3.5 trillion - a level that would currently require a nearly $800 billion contraction just to normalize short-term interest rates by a quarter of one percent.
The central effect of QE is not on the real economy, but on financial speculation. The Fed purchases Treasury and mortgage securities, and creates new base money (currency and bank reserves) as payment. This results in a huge pool of zero-interest assets that someone in the economy has to hold at any given point in time. This zero-interest money is a "hot potato" that creates discomfort and encourages a tendency to "reach for yield" in more speculative assets. Undoubtedly, the universal attention to Fed actions has already created a mob psychology where, to use Kindleberger's words, "virtually each of the participants in the market changes his or her views at the same time and moves as a herd."
It's worth observing that the 10-year Treasury yield is also well above the weighted average interest rate since 2010 (weighting by the quantity of Fed purchases), which means that the Fed is underwater on its holdings. Bernanke himself noted at his recent Humphrey-Hawkins testimony that the recent rise in interest rates had wiped out all of the Fed's unrealized gains, though he feigned ignorance about how much the Fed would lose if interest rates increased by 100 basis points. The math is easy enough, so let's do it for him. At $3.5 trillion in assets having an estimated duration of about 8 years, against only $55 billion in capital, a 100 point increase in interest rates would wipe out the Fed's capital five times over. The Fed would probably show an insolvent balance sheet today if its holdings were actually marked-to-market.
The boom of the Minsky model is fueled by the expansion of credit. Minsky noted that 'euphoria' might develop at this stage. Investors buy goods and securities to profit from the capital gains associated with the anticipated increases in their prices. The authorities recognize that something exceptional is happening and while they are mindful of earlier manias, 'this time it's different,' and they have extensive explanations for the difference.
"The continuation of the process leads to what Adam Smith and his contemporaries called 'overtrading.' This term is not precise and includes speculation about increase in the prices of assets or commodities, an overestimate of prospective returns, and 'excessive leverage.' Speculation involves buying assets for resale at higher prices rather than for their investment income. The euphoria leads to an increase in optimism about economic growth and about the increase in corporate profits.
"A follow-the-leader process develops as firms and households see that speculators are making a lot of money. 'There is nothing as disturbing to one's well-being and judgment as to see a friend get rich.' Unless it is to see a non-friend get rich.
"Investors rush to get on the train even as it accelerates. As long as the outsiders are more eager to buy than the insiders are to sell the prices of the assets or securities increase. As the buyers become less eager and the sellers become more eager, an uneasy period of 'financial distress' follows. Other words used to describe the interval between the end of euphoria and the onset of what classic writers called revulsion and discredit (or crash and panic) are uneasiness, apprehension, tension, stringency, pressure, uncertainty, ominous conditions, fragility.
We've learned all too well that each round of QE has at least enough impact to kick the can down the road for a couple of quarters at a time, at the cost of greater distortions. As thoughtful economists like Lakshman Achuthan and value investors like Jeremy Grantham and Seth Klarman know, this has temporarily made fools out of geniuses and geniuses out of fools. So refraining from any forecast of what will happen in the near term, it's sufficient to observe that the economic data is not nearly as strong as widely perceived, and the impact of QE on stock prices does nothing to improve the underlying cash flows. The advance of recent months has only made the prospect for dismal long-term equity returns even worse. QE has no ability to improve that situation. At this point, it can only elevate the distortion and thereby worsen the outcome. It's doubtful that investors who are enjoying the thrill of recent highs will actually realize the benefit of these prices.
Will QE Cause Inflation?
Inflationists and hyperinflationists have a watchful eye on the rise in treasury yields. Forget about it. I explained why in Message to 5.7 Million Truck Drivers "No Drivers Needed" Your Job is About to Vanish; Time Marches On, Fed Resistance is Futile.
John Hussman offers a similar take in The Price of Distortion
With respect to monetary policy, the Fed has now pushed the size of the monetary base to over 20 cents per dollar of nominal GDP. We know from a century of data that short-term interest rates are tightly linked to the monetary base.
Essentially, as the Fed creates more zero-interest money (relative to nominal GDP), cash becomes a "hot potato" and holders of cash seek alternatives, which drives down competing yields, particularly on "near-money" like Treasury bills. At present, the Fed is pushing on a string, and the entire force of Fed policy is based on the attempt to drive investors to hold securities of greater and greater risk in return for lower and lower prospective returns. All this despite decades of data that reject the notion of a material "wealth effect" from stock values to economic activity. People consume from their view of "permanent income" and do not respond to changes in the value of volatile assets - this is well established in both theory and evidence.
Note how far we have pushed the string. The Fed would have to reduce its portfolio by well over half to raise interest rates to 2%. So even if the Fed was to completely terminate new purchases of Treasury securities, that action would not be expected to raise short-term interest rates. This underscores the fact that reducing the pace of quantitative easing is not the same thing as raising the Fed's policy rates. But it should also underscore how far the Fed's policy has already gone, and how difficult it will be to normalize over time.
Frankly, I view the present course of monetary policy as reckless - not because it threatens inflation (which I don't think it will for several years), but because it diverts scarce capital away from productive investment and toward speculative activities; because it fails to act on any economic constraint that is actually binding here, so has little hope of providing the economic "support" that it purports to offer; because decades of historical evidence provide no basis to expect a material "wealth effect" from stock values to the economy; because the policy lowers hurdle rates and encourages borrowing for unproductive purposes - including stock buybacks at record highs (and there is no evidence that buybacks are a good indication of value); because it punishes the elderly on fixed incomes; because it perpetuates a bubble-bust cycle created by Fed intervention, which is not the medicine but the very poison itself; and because moving to the left on the liquidity preference curve will likely be as painful as moving to the right has been pleasant. Meanwhile, we'll continue along a studied, disciplined course over the remainder of this market cycle, considering a broad ensemble of evidence that has been validated across market cycles throughout history. Our views will change as that evidence does.
Another Looming Credit Crunch?
Let's wrap up the discussion with a look at Another Looming Credit Crunch?
Thanks to an over-flowing cup of Fed liquidity, corporate debt maturities have not only been pushed out in time but have risen in their nominal outstandings as cheap financing was too good to ignore (especially for those firms on the bubble of failure). The problem these firms face now is, with the Fed set to Taper (and indeed tighten on rates in the next few years); the outlook of much higher bond yields will have a major impact on firms that levered up and used this period to 'survive'.
As is clear from the chart above, debt maturities [rollovers and refinancing needs] will once again surge in 2-3 years. The message once again appears to be - there's no free lunch as the Fed has merely dragged forward exuberance at the expense of dystopia in the not so distant future.
Four Questions Four Answers
Here is a short recap of all the questions asked and answered above
- US in a Minsky Bubble? Yes - And one of huge magnitude as well
- About to Go Japanese? Yes - Fed policies ensure that outcome
- Will QE Cause Inflation? No - Not any time soon
- Another Looming Credit Crunch? Yes - Corporations will not be able to roll over debts at such low rates again