They finally did it – 25 bps, for the first rate increase since 2004. Surely it’s the most dovish Fed “tightening” ever. Indeed, it was really no tightening at all. One has to go all the way back to 1994 for the last time the Federal Reserve commenced a true tightening cycle. That episode proved so destabilizing that the Federal Reserve assured the markets that they’d learned their lesson. And this (dovish and market-pandering) mindset was fundamental to the little baby step rate increases that ensured no tightening of financial conditions throughout the historic 2002-2007 mortgage finance Bubble inflation.
This week’s policy move will be debated for years to come. Lost in the debate is how the Fed (along with global central bankers) found itself stuck at zero for seven years (with a $4.5 TN balance sheet) and then saw it necessary to move to raise rates in the most gingerly, market-pleasing approach imaginable.
Traditionally, tightening cycles are necessary to counter mounting excess, including ill-advised lending, speculating and investing. Rate increases back in 1994 exposed what had been a dangerous expansion in speculative leveraging, derivatives and market-based Credit (at home and abroad). With the “bond” market in disarray and Mexico at the precipice, the Greenspan Fed turned its attention to bolstering the markets and non-bank Credit more generally.
Market-based Credit is unstable. This remains the fundamental issue – the harsh reality – that no one dares confront. I would strongly argue that long-term stability in a Capitalistic system requires sound money and Credit (hopelessly archaic, I admit). Over the years, I’ve tried to differentiate traditional finance from unfettered “New Age” finance. The former, bank lending-dominated Credit, was generally contained by various mechanisms (including the gold standard, effective currency regimes, bank capital and reserve requirements, etc.). This is in stark contrast to the current-day securities market-based global financial “system” uniquely operating without restraints on either the quantity or quality of Credit created.
A few data points from the Federal Reserve’s “Z.1” report illuminate why the Credit system had turned fragile back in 1994. After beginning the decade at $6.39 TN, Total Debt Securities (my compilation of Treasuries, Agency Securities, Corporate Bonds and Muni Debt) surged $2.94 TN, or 46%, in four years to end 1993 at $9.33 TN. For comparison, over this period bank (“Private Depository Institutions”) Loans actually declined $169 billion (Total bank Assets rose $137bn to $4.9 TN). Importantly, Total Debt Securities as a percentage of GDP jumped from 113% to 135% in four years, while bank Loans to GDP declined from 57% to 44% (bank Assets 84% to 71%).
Fast-forward to 2014 and securities-based finance completely dwarfed bank loans. Total Debt Securities had inflated to $21.11 TN, or 172% of GDP. At $6.32 TN, bank Loans had increased only marginally to 51% of GDP. It’s worth noting that Equities as a percentage of GDP ended 2004 at 154%, up from 1994’s 86%. Total (Debt & Equities) Securities, at $40 TN, ended 2004 at a then record 326% of GDP. This compares to 1994’s $16.2 TN, or 222%.
The 2008 crisis exposed the incredible leveraged that had accumulated over a protracted period of Fed-induced easy money. It’s my view that Fed policies were used specifically to reflate the securities market Bubble in 1998 and then again in 2001-2002. This then precluded the Fed from adopting real tightening measures throughout the mortgage finance Bubble period that would have risked financial crisis.
Importantly, market-based finance did not equate to freer markets. Indeed it was the exact opposite. Policies at the Greenspan Fed evolved from actively supporting the securities markets and promoting speculation to desperate measures to sustain the Bubble. Dr. Bernanke arrived at the Fed in 2002 with an inflationist ideology to use “helicopter money” to reflate Credit and securities market Bubbles. Ironically, market-based finance became the most powerful tool for central bank manipulation - so powerful that the central planners at the Chinese communist party rushed to adopt securities-based finance.
Post-mortgage finance Bubble reflationary measures inflated the global securities Bubble to historic extremes. Here at home, Total Securities ended 2014 at $74.54 TN, or 430% of GDP. Debt Securities ended the year at $38.3 TN, or 221% of GDP, with Equities at $36.2 TN, or 209% of GDP.
There’s no precedence for such a globalized monetary fiasco, though there are a number of historical episodes that provide valuable insight. John Law’s introduction of paper money in France (1716-1720) and the resulting “Mississippi Bubble” is one of my favorites. The basic flaw in Law’s inflationist theories was his focus on the “medium of exchange” attribute to the exclusion of money’s critical role as a “store of value.” Pertinent as well, when confidence in Law’s financial scheme began to wane, he devalued competitive hard currencies in a desperate attempt to sustain demand for his scheme of paper money and securities. Bernanke, Draghi, Kuroda, Yellen and their central bank colleagues inflate central bank Credit as a “medium of exchange” for securities market inflation and apparently don’t contemplate the “store of value” dilemma that has torpedoed inflationism’s grand illusions throughout history.
The late-twenties period provides invaluable insight: The extreme divergence between the trajectory of commodities and securities prices. Benjamin Strong’s 1927 “coup de whiskey” (Draghi’s 2012 “do whatever it takes”). Policymaker confusion about the nature of inflation. How new technologies, a prolonged investment boom and booming global trade fostered confounding price instabilities. The critical issue of productive vs. non-productive Credit. How the Fed sought to promote capital investment, yet the allure of a speculative securities market Bubble proved too powerful. That there was little understanding of how securities market leverage had fostered acute market, financial and economic fragility. Especially late in the boom, the Fed was in no way in control of either inflation or the flow of finance through the markets and real economy. How everyone was determined to hold their ground, yet the ground gave way beneath them.
“In order to believe you should raise rates for financial stability reasons, you have to believe that there’s a serious problem of over-confidence – of bubble formation. And it seems to me that most of the plausible bubbles are no longer plausible bubbles at this point. Perhaps you could have said there was a bubble element in the high-yield bond market at some point, but you certainly can’t say that today. Perhaps you could have said that about emerging markets at some point. You can’t say it today. Perhaps you could have said it about commodities at some point. You can’t say that today. So the notion of raising rates today as a prophylactic against financial instability seems quite odd. I think we’re much more likely to have problems that come from under-confidence in financial markets than problems that come from over-confidence in financial markets.” Former U.S. Treasury Secretary Larry Summers speaking with Bloomberg’s Tom Keene, December 15, 2015
Unfortunately, Plausible Bubbles Abound. Junk bonds are merely the Periphery of a historic Bubble throughout corporate Credit and debt securities more generally. Troubled EM markets are merely the Periphery of a historic Credit Bubble throughout Latin America, Eastern Europe and Asia, certainly including the runaway mega Chinese Bubble (at the Core). Commodities are merely the Periphery of a historic global speculative Bubble, with financial assets at The Massive Core.
And the dilemma for John Law, for the late-1920s period, during 2007 and again these days: easy money policies meant to support a faltering Periphery work generally to exacerbate excess at the Bubble’s Core. As an analyst of Bubbles, the great challenge is to try to recognize when trouble at the Periphery, rather than supporting continued "Terminal Excess" at the Core, begins to lead to risk aversion, de-leveraging and a tightening of financial conditions at the vulnerable Core.
It was a tricky week. To have such an important policy announcement two days prior to a year-end “quadruple witch” options expiration added complexity. The Fed basically gave the markets exactly what they were expecting, providing reason enough to rally. This rally, right before expiration, was fueled by an unwind of hedges and bearish positions. Yet it wasn’t long before deteriorating fundamentals trumped the Fed’s dovish rate increase. I have not agreed with the conventional thinking that global instability has been mainly about the Fed. So I don’t subscribe to analysis that sees the Fed hike now reducing uncertainty and engendering stability.
The Brazilian real declined 2.7% this week. Brazilian stocks sank 3.0%. Devaluation saw the Argentine peso collapse 36%. Argentina’s Merval equities index sank 10.8% this week. Crowded trades and a proliferation of derivative trading ensure some big bear market rallies. But the bursting of the EM and commodities Bubbles runs unabated. It’s as well worth noting that the yen gained 1.1% against the dollar Friday when the BOJ surprised the market with expanded stimulus measures but disappointed by not boosting QE.
December 18 – Wall Street Journal (Aaron Back): “Bank of Japan Governor Haruhiko Kuroda may have thought he was giving markets an early Christmas present. But investors reacted like they were finding coal in their stockings. The BOJ was widely expected not to make any adjustments to its easing program on Friday. So when headlines hit that it was making moves—extending the maturity of its government bond portfolio and introducing a new stock buying program—reaction was ecstatic. The Nikkei 225 surged by over 2% in minutes. But as traders read through the text of the BOJ statement, elation gave way to befuddlement. Japanese stocks ended the day down 1.9%. The new measures don’t amount to extra easing by any significant degree.”
Until recently, markets remained sanguine in the face of downward pressures on commodities as well as general global consumer and producer price indices. After all, “do whatever it takes” central bankers would be compelled to increase QE to reach their so-called “inflation mandates”. Regarding QE and the global drive to increase inflation, it’s been “If it’s not working just do more of it.” And speculative markets have absolutely loved the QE bonanza. At some point, however, central bankers had to face the reality that QE is highly destabilizing – and not all that effective. First it was the ECB. Now the BOJ. Reality is beginning to set in. “Do whatever it takes” has limits, especially when it comes to QE. Suddenly, the bursting EM and commodities Bubbles appear a lot more problematic.