Chronicling For Posterity

By Doug Noland

Credit Bubble Bulletin: Chronicling For Posterity

Janet Yellen’s Wednesday news conference was her final as Fed chair. Dr. Yellen has a long and distinguished career as an economist and public servant. Her four-year term at the helm of the Federal Reserve is almost universally acclaimed. History, however, will surely treat her less kindly. Yellen has been a central figure in inflationist dogma and a fateful global experiment in radical monetary stimulus. In her four years at the helm, the Yellen Fed failed to tighten financial conditions despite asset inflation and speculative excess beckoning for policy normalization.

Ben Bernanke has referred to the understanding of the forces behind the Great Depression as “the holy grail of economics.” When today’s historic global Bubble bursts, the “grail” quest will shift to recent decades. Yellen’s comments are worthy of chronicling for posterity.

CNBC’s Steve Liesman: “Every day it seems we look at the stock market, it goes up triple digits in the Dow Jones. To what extent are there concerns at the Federal Reserve about current market valuations? And do they now or should they, do you think, if we keep going on the trajectory, should that animate monetary policy?”

Chair Yellen: “OK, so let me start, Steve, with the stock market generally. I mean, of course, the stock market has gone up a great deal this year. And we have in recent months characterized the general level of asset valuations as elevated. What that reflects is simply the assessment that looking at price-earnings ratios and comparable metrics for other assets other than equities, we see ratios that are in the high end of historical ranges. And so that’s worth pointing out.

But economists are not great at knowing what appropriate valuations are; we don’t have a terrific record. And the fact that those valuations are high doesn’t mean that they’re necessarily overvalued. We are in a — I mentioned this in my opening statement and we’ve talked about this repeatedly – likely a low interest rate environment, lower than we’ve had in past decades. And if that turns out to be the case, that’s a factor that supports higher valuations, where enjoying solid economic growth with low inflation and the risks in the global economy look more balanced than they have in many years.

So, I think what we need to and are trying to think through is if there were an adjustment in asset valuations, the stock market, what impact would that have on the economy? And would it provoke financial stability concerns? And I think when we look at other indicators of financial stability risks, there’s nothing flashing red there or possibly even orange. We have a much more resilient, stronger banking system. And we’re not seeing some worrisome buildup in leverage or credit growth at excessive levels. So, this is something that the FOMC pays attention to. But if you ask me is this a significant factor shaping monetary policy now, well it’s on the list of risks. It’s not a major factor.”

Reuter’s Howard Schneider: “So you mentioned in response to Steve’s question that asset valuations, you didn’t think, were on the high-priority risk list right now. So I’m wondering what do you think is on that risk list? And more broadly, what have you left undone? You’ve gotten high marks for bringing the economy back towards its goals, but are there things that are going to nag you when you walk out of here in February, and say, ‘Really, I wish I’d seen this to completion’? I mean, we’re not doing negative interest rates. We’re not doing inflation framework. What’s at the top of the to-do list that you are not getting to see to bring to ground here?”

Yellen: “So you asked about the risk list. There are always risks that affect the outlook. We tend to focus, in our own evaluation, on economic risks. And we’ve characterized them as balanced, and I think they are balanced. I can always give you a list of, you know, potential troubles, international developments that could result in downside economic risk.

But look, at the moment the U.S. economy is performing well. The growth that we’re seeing it’s not based on, for example, an unsustainable buildup of debt, as we had in the run-up to the financial crisis. The global economy is doing well. We’re in a synchronized expansion. This is the first time in many years that we’ve seen this. Inflation around the world is generally low. So I think the risks are balanced, and there’s less to lose sleep about now than has been true for quite some time. So I feel good about the economic outlook…

As I mentioned, I think the financial system is on much sounder footing, and that we have done a great deal to put in place greater capital, liquidity, and so forth that make it less crisis-prone, and that has been an important objective. What’s on my undone list, you ask? We have a 2% symmetric inflation objective, and for a number of years now, inflation has been running under 2%, and I consider it an important priority to make sure that inflation doesn’t chronically undershoot our 2% objective. And I want to see it move up to 2%. So most of my colleagues and I do believe that it’s being held down by transitory factors, but there’s work undone there in the sense we need to see it move up in line with our objective.”

Bloomberg’s Mike McKee: “…Do you think that there is any Fed blame or complicity in the flattening of the yield curve, and are you worried that there might be some sort of policy mistake built into that that could slow the economy?”

Yellen: “The yield curve has flattened some as we’ve raised short rates. The flattening curve mainly reflects higher short-term rates. The yield curve is not currently inverted, and I would say that the current slope is well within its historical range. Now there is a strong correlation historically between yield curve inversions and recessions. But let me emphasize that correlation is not causation. And I think that there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed. One reason for that is that long-term interest rates generally embody two factors: One is the expected average value of short rates over, say, ten years. And the second piece of it is a so-called term premium that often reflects things like inflation and inflation risk. Typically, the term premium historically has been positive. So when the yield curve has inverted historically, it meant that short-term rates were well above average expected short rates over the longer run – so with a positive term premium that’s what it means. And typically that means that monetary policy is restrictive – sometimes quite restrictive. And some of those recessions were situations in which the Fed was consciously tightening monetary policy because inflation was high and trying to slow the economy. Well, right now the term premium is estimated to be quite low – close to zero. And that means that structurally – and this could be true going forward – that the yield curve is likely to be flatter than it’s been in the past. And so it could more easily invert if the Fed were to even move to a slightly restrictive policy stance – could see an inversion with a zero term premium. So, I think the fact the term premium is so low and the yield curve is generally flatter is an important factor to consider.” 

The yield curve has become, once again, a critical Bubble issue. Recall Alan Greenspan’s “conundrum.” The Greenspan Fed raised short-term rates 350 bps (June ’04 to January ’06) yet 10-year Treasury yields barely budged (around 4.5%). After trading as high as 273 bps in 2003, the spread between two-year and 10-year Treasuries ended 2004 at 115 bps and 2005 at about flat. The yield curve inverted as much as 18 bps in November 2006.

Keep in mind that system Credit was expanding by record amounts, fueled by years of compounding double-digit annual mortgage Credit growth. Annual Total Non-Financial Debt (NFD) growth averaged $760 billion during the decade of the nineties. By 2002, NFD was up to $1.346 TN and accelerating rapidly. NFD expanded $1.654 TN in 2003, $2.115 TN in 2004, $2.291 TN in 2005, $2.416 TN in 2006 and $2.509 TN in 2007. Clearly, a flat or inverting yield curve was not explained by restrictive monetary policies.

The fundamental issue was not so much that market yields were not rising in response to Fed “tightening” measures. Rather, why were borrowing rates not increasing in the face of unprecedented demand for Credit? How had the price of finance become completely disconnected from underlying demand? And, critically, why was the Credit system not self-adjusting and correcting, but instead fueling a runaway mortgage finance Bubble?

Arguing asset price valuations back in the 2004 to 2007 Bubble period was as futile as it is today. It was the yield curve that signaled something was seriously amiss. The so-called “conundrum” needed serious contemplation, not clever self-serving rationalization and justification (i.e. “global savings glut”). Moreover, the anomalous yield curve was providing important corroboration of anomalous Credit growth data.

Finance had been fundamentally altered. Contemporary Credit systems, increasingly dominated by market-based finance, were essentially operating with unlimited supply. Somehow, a rapid doubling of mortgage Credit in just over six years neither stressed the supply of Credit nor evoked higher risk premiums. Instead of self-correction, this new financial apparatus was a self-reinforcing Bubble machine. The system had badly malfunctioned, though the ugly reality remained camouflaged until later in 2008. In the meantime, it flaunted a pretense of being both phenomenal and sustainable.

The yield curve has again flattened significantly in 2017. The two-year to 10-year Treasury spread ended Friday’s session at 51 bps, down from the 125 bps to start the year, to the narrowest spread since the heydays of Bubble excess back in 2007. Short-rates have risen, the economy has gathered momentum and prospects for an uptick in inflation have increased. What’s behind the replay of the “conundrum”?

On one point, I concur with chair Yellen: “I think there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed.” But I would posit that this change evolved over recent cycles, as central bankers took an increasingly activist role in the economy and, most importantly, throughout the financial markets.

I would argue that the yield curve flattened in’06 and ’07 specifically because of Bubble Dynamics in mortgage Credit coupled with Bernanke’s previous professing on “helicopter money” and the government printing press. Dr. Bernanke, a radical inflationist, had become a powerful force in Federal Reserve policymaking. Bond markets back then discerned mortgage finance Bubble unsustainability, while deftly anticipating the Federal Reserve’s crisis response. The bursting Bubble saw the formal unveiling of the new central bank modus operandi: slash short rates to at least zero; aggressively inject liquidity into the markets through long-term debt purchases; manipulate long-term market yields much lower while telegraphing unwavering liquidity support.

The Fed and conventional thinking are comfortable with the view that today’s flat yield curves (low long-term yields) signal ongoing disinflationary pressures. The talk is of an extraordinarily low “neutral rate” that, conveniently, necessitates ongoing aggressive monetary accommodation. Apparently, financial stability concerns remain undeserving of the Fed’s “risk list”, so long as core consumer prices remain (slightly) below the 2% target.

December 13 – Reuters (John Ruwitch and Winni Zhou): “Financiers keep pouring cash into the shale oil sector, providing producers with a path to keep U.S. output rising through the middle of the next decade. The United States is on track to deliver up to 80% of the world’s oil production gains through 2025, the International Energy Agency estimates, increases fueled in part by easy access to capital. Rising U.S. production is undermining OPEC’s attempts to curb global supply and boost prices, forcing the oil cartel to continue restraining output through the end of 2018. Hedge funds and private equity firms have given producers a range of new and traditional financial levers they can pull as needed to keep shale rigs drilling…”

In so many ways, years of loose finance have spurred over-investment and attendant downward pricing pressures. Shale finance is only one of the more visible examples. Importantly, excess cheap finance and investment have evolved into powerful global phenomena. One has only to point to the runaway Credit boom – and resulting manufacturing overcapacity in China (and Asia more generally) – to come to the rather obvious conclusion that activist monetary management/accommodation can foment downward pricing pressures.

These days, central bankers from around the globe sing from the same hymn sheet. The inflation backdrop demands ongoing stimulus. The yield curve is “within its historical range”. “The financial system is on much sounder footing.” There’s “less to lose sleep about.” “When we look at other indicators of financial stability risks, there’s nothing flashing red there or possibly even orange. We have a much more resilient, stronger banking system. And we’re not seeing some worrisome buildup in leverage or credit growth at excessive levels.” When it comes to mounting risk throughout global securities and derivative markets, it’s hear no evil, see and speak none either. It’s worth highlighting an exchange from Mario Draghi’s Thursday press conference”

Question: “What kind of discussions have been going on within the governing council about possible bubbles in sectors of the market or economy – and how exiting the asset purchase plan could impact those bubbles?”

Mario Draghi: “We always discuss financial stability issues, and we certainly closely monitor the financial stability risks that may emerge from a situation where we had very, very low interest rates for a long period of time; abundant liquidity for a long period of time. So, the ground is fertile for these risks. At the same time, we are not seeing systemically important financial stability risks. We see the local spots where valuations tend to be over-stretched. But also, as soon as you ask this question, one should also ask the question ‘How’s leverage?’ Because a bubble is also the outcome of two components. So how’s leverage behaving? And there, differently from other parts of the world, we don’t see leverage – for the private sector going up, as for the whole of the Eurozone. As a matter of fact, debt to GDP or debt to value of assets – depending on the yardstick – continues to decrease…”

My response: Proclaiming a lack of “private sector” leveraging is disingenuous when the greatest sources of systemic leverage throughout this long cycle have been ballooning central bank and government balance sheets. It recalls how pristine government finance was an important facet of the last cycle’s bull story. Meanwhile, massive leveraging by the private and financial sectors was behind the mirage of responsible fiscal management.

As for Draghi’s “local spots” of “over-stretched” valuations, could he be referring to Italian 10-year yields at 1.80% or Spain at 1.49%? Or perhaps Greece at 3.89%, or Portugal at 1.76%. Or could it be German 10-year yields at 0.29%, or perhaps German two-year yields at negative seven bps. And then there’s French 10-year yields at 0.62%, Switzerland at negative 0.24%, Finland at 0.45%, Ireland at 0.48%, Belgium at 0.49%, Netherlands at 0.40%, Austria at 0.45% or Slovenia at 0.69%.

It’s reminiscent of chairman Greenspan’s declaration that you won’t have a national real estate Bubble because all real estate markets are local. The flaw in the maestro’s thinking was his apparent disregard for the Bubble throughout mortgage finance – very much on a systemic, national basis. Today’s Bubble is in finance on a systemic, global basis – most prominent in government, central bank and securities finance – developed, EM and, importantly, all things China. Leveraging galore – with the associated Bubble finance utterly “fungible.”

December 13 – Bloomberg (Chris Anstey): “European investors have been plowing so much capital abroad they’ve taken up about half the boom in U.S. corporate debt in recent years, but now that liquidity tap is poised to be shut off, according to Oxford Economics. ‘The global debt issuance boom is likely to lose steam, given the extent to which it has relied on the support of European investors,’ Guillermo Tolosa, an economic adviser to Oxford Economics in London who has worked at the International Monetary Fund, wrote… ‘Issuers better seize the opportunities while they last.’ European Central Bank asset purchases took up so great a supply of bonds that it pushed euro area investors into markets abroad, to the tune of 400 billion euros ($473bn) a year over the past three years, Oxford Economics estimates.”

It’s simply difficult to believe that these central bankers fail to recognize what have evolved into deeply systemic risks. They know they’re trapped, but in denial – right? Then again, complacent central bankers have a history of being blindsided. Clearly, they’re determined to cling to flawed doctrine. I’ve always believed conventional thinking has it wrong: The great risk is not deflation but runaway Credit Bubbles. And very serious problems unfold when the risk of a bursting Bubble ensures that policymakers rationalize, justify – and sit back and do nothing.

December 12 – CNBC (Tae Kim): “Stanley Druckenmiller believes the overly easy monetary policies by global central banks will have disastrous consequences. ‘The way you create deflation is you create an asset bubble. If I was ‘Darth Vader’ of the financial world and decided I’m going to do this nasty thing and create deflation, I would do exactly what the central banks are doing now,’ he told CNBC’s Kelly Evans… ‘Misallocate resources [with low interest rates], create an asset bubble and then deal with the consequences down the road,’ he said. The investor noted how this boom-and-bust cycle has happened time and time again. ‘Deflation just doesn’t appear out of nowhere and it doesn’t happen because you are near the zero bound. Every serious deflation I’ve looked at is preceded by an asset bubble and then it bursts,’ he said. ‘Think about the ’20s, a big asset bubble that burst, you have the Depression. Think about Japan. Asset bubble in the ’80s. It burst. You have the consequences follow. Think about 2008, 2009.’”

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