Must Stop Digging

By Doug Noland

Credit Bubble Bulletin: Must Stop Digging

Amazon, Google, Microsoft, Intel and Draghi all handily beat expectations. Booming technology earnings confirm the degree to which Bubble Dynamics have become entrenched within the real economy. Draghi confirms that central bankers remain petrified by the thought of piercing Bubbles.

There is a prevailing view that Bubbles reflect asset price gains beyond what is justified by fundamental factors. I counter with the argument that the inflation of underlying fundamentals – revenues, earnings, cash-flow, margins, etc. – is a paramount facet of Bubble Dynamics (How abruptly did the trajectory of earnings reverse course in 2001 and 2009?).

With extremely low rates, loose corporate Credit Availability, large deficit spending, inflating asset prices and a glut of “money” sloshing about, there is bountiful fodder for spending and corporate profits. And with technology one of the more beguiling avenues to employ the cash-flow bonanza – and tech start-ups, the cloud, AI, Internet of Things, robotics, cybersecurity, etc. white-hot right now – the Gargantuan Technology Oligopoly today luxuriates at the Bubble Core.

By this time, expanding global technology capacity is a straightforward endeavor, while the industry for now enjoys booming demand and outsized margins. This confluence of extraordinary attributes provides “tech” the latitude to operate as a powerful black hole absorbing global purchasing power (throughout economies as well as financial markets). As such, it has been a case of the greater the scope of the Bubble, the more supply of “tech” available to weigh on overall goods and services pricing pressures. Central bankers continue to misconstrue this dynamic, instead perceiving irrepressible disinflationary forces that they are compelled to counter (with year after year after year of flagrant monetary stimulus).

The Nasdaq Composite’s 24.5% y-t-d gain has provided a fantastic windfall to fortunate investors as well as tens of thousands of extremely fortunate employees. This financial godsend will exacerbate wealth disparities along with housing inflation in select localities. Yet there will be little boost to reported wages (capital gains instead) and negligible impact on the overall CPI index. Is CPI these days even a relevant gauge of inflationary pressures or monetary instability?

As for Mario Draghi’s practice of beating market expectations, he is the present-day Alan Greenspan – the savvy operator that over the years has grown too comfortable wielding power over global markets (not to mention over central bankers at home and abroad). Headline from the Financial Times: “Draghi Pulls Off Dovish Trick with His QE ‘Downsize’ – ECB President Determined Not to Repeat Mistake of Premature Tightening.”

The ECB – right along with central bankers around the globe – has replayed the fateful mistake of delaying for (way) too long the removal of monetary stimulus. Draghi refused to set a date to end the ECB’s “money” printing operations, ensuring at least several hundred billion of additional stimulus in 2018. And with the commitment to hold rates at the current negative level until well past the end of QE, a most inert “normalization” process will not even commence until well into 2019. Apparently, short rates likely won’t make it much past 1% for several years. Draghi’s central bank will continue to purchase large quantities of corporate debt next year. Moreover, with open-ended QE and assurances that operations could at any point be expanded, spoiled markets take great comfort that their beloved liquidity backstop is as unyielding as ever.

October 26 – Bloomberg (Alessandro Speciale and Mark Deen): “The European Central Bank should have decided on an end date for its asset-purchase program rather than retaining the option to extend it after September 2018, Bundesbank President Jens Weidmann said. ‘From my point of view, a clear end of net purchases would have been appropriate,’ Weidmann said in a speech… ‘The development of domestic price pressures shown in projections is in line with a trajectory that will take us toward our definition of price stability.’ Weidmann’s critique comes one day after the Governing Council extended quantitative easing until September at a monthly pace of 30 billion euros ($35bn), leaving the door open for further buying after that if needed. The Bundesbank president was among a handful of policy makers who didn’t support the decision, according to Germany’s Boersen-Zeitung.”

German stocks gained 1.7% this week, while French equities jumped 2.3%. German (38bps) and French (79bps) yields declined seven basis points to seven-week lows. Portuguese bond yields dropped 11 bps to a 30-month low 2.19%. Dropping nine bps, Italian 10-year yields traded back below 2%. And in a sign of these strange times, even Catalonia chaos couldn’t keep Spanish yields from declining eight bps to 1.58% (83bps below Treasuries!). Yet Draghi has company when it comes to assuring markets that central bank liquidity backstops are here to stay.

October 20 – Financial Times (Sam Fleming): “Janet Yellen… has warned that there is an ‘uncomfortably high’ risk that the central bank will have to deploy crisis-era stimulus tools again — even in the case of a less severe downturn than the Great Recession. Her comments come as President Donald Trump considers a sharp change of direction at the Fed which could see him install new leadership that is much more dubious about the Fed’s use of quantitative easing. Ms Yellen said in a speech that the US economy had made ‘great strides’ but that policymakers may be unable to lift short-term rates very far as the recovery proceeds. This could leave the Fed once again leaning on quantitative easing and forward guidance on the future rate outlook when the economy hits a downturn, she suggested… ‘Does this mean that it will take another Great Recession for our unconventional tools to be used again? Not necessarily. Recent studies suggest that the neutral level of the federal funds rate appears to be much lower than it was in previous decades,’ Ms Yellen said. ‘The bottom line is that we must recognise that our unconventional tools might have to be used again. If we are indeed living in a low-neutral-rate world, a significantly less severe economic downturn than the Great Recession might be sufficient to drive short-term interest rates back to their effective lower bound.’”

Apparently, there is an “uncomfortably high risk” that QE will be employed “in the case of a less severe downturn” because “policymakers may be unable to lift short-term rates very far as the recovery proceeds.” Does anyone believe that the Yellen Fed is less than comfortable with the prospect of restarting QE?

Q3 marked the second consecutive quarter of 3% U.S. growth; consumer confidence is the highest in years; stock markets are booming with record prices and “money” flooding into ETFs; debt issuance remains on record pace; leveraged lending and M&A are booming; a strong inflationary bias persists in housing; and the unemployment rate is down to 4.2%, lowest in 16 years. Why not begin a real normalization of monetary policy? Because some measures of core consumer price inflation remain slightly below 2.0%?

It has become increasingly apparent that central bankers recognize their predicament and have chosen not to risk piercing Bubbles. I suspect Draghi, Yellen and Kuroda (and others) fear the consequences of a destabilizing jump in global bond yields. I too fear the amount of leverage and range of distortions that have accumulated over the past nine years. The inescapable adjustment after such a prolonged boom will be quite difficult. Yet the analysis gets back to the “First Law of Holes:” Must Stop Digging. At this late (historic) Bubble stage, systemic risk is piling up exponentially.

October 24 – Financial Times (Robin Wigglesworth): “Inflows into exchange-traded bond funds have surged past last year’s record with several months to spare, as the seismic migration towards passive investing broadens out beyond the equity market. ETFs that track fixed-income benchmarks have attracted nearly $130bn so far this year, comfortably surpassing the record-breaking 2016, when almost $117bn gushed into bond ETFs… Bloomberg data puts this year’s inflows at more than $140bn. ‘It’s been a year of robust flows,’ said Steve Laipply, head of fixed income strategy at BlackRock’s iShares ETF business… ‘There has been accelerating institutional investor adoption of these products’… ETF providers such as Vanguard, State Street and BlackRock have rapidly grown their franchises, with BlackRock revealing in its latest quarterly earnings that it is currently taking in about $1.5bn a day.”

October 22 – Wall Street Journal (Christopher Whittall): “Investors hungry for returns are piling back into securities once tarnished by the financial crisis. Complex structured investments developed a bad reputation during the credit crunch. Ten years later, investors seeking yield are overcoming their skepticism and buying into securities that rely on financial engineering to juice returns. Volumes of CLOs, or collateralized loan obligations, hit a record $247 billion in the first nine months of the year… Fueled by a wave of refinancings and nearly $100 billion in new deals, that far outpaces their recent full-year high of $151 billion in 2014 and the precrisis peak of $136 billion in 2006. The CLO boom is the latest sign of the ferocious hunt for yield permeating markets. Stellar performance over the past year has made CLOs increasingly hard to ignore for investors like insurance companies and pension funds.”

October 20 – Financial Times (Gillian Tett): “A decade ago, whenever I chatted to anyone at Switzerland’s Bank for International Settlements, I felt like I was hobnobbing with dissidents. The reason? Back then, most western central bankers and finance ministers were convinced that the global economy was in good shape: inflation was low, growth was steady, corporate and consumer optimism was high. In fact, the data seemed so benign that economists had labelled the first decade of the 21st century the ‘great moderation’. Not the BIS. Starting in 2003, officials at… institution, which aims to ‘promote global monetary and financial stability through international co-operation’, started to warn that the world economy was plagued by excessive levels of debt. This made the system dangerously distorted; so went the off-the-record murmurs from men such as William White… and Claudio Borio… Most central bankers dismissed these warnings — some even tried to silence the BIS… Earlier this month I travelled to Washington for an International Monetary Fund and World Bank meeting. There was a cheery mood in the air, just as there was in 2006… But now, just as before, those BIS dissidents are muttering in the wings. At the IMF gala, Borio (still at the BIS) told me that the pesky matter of debt has not disappeared. On the contrary, since the 2008 credit crisis, it has risen sharply: the level of global debt to gross domestic product is now 40% — yes, 40% — higher than it was in 2008. The world has responded to a crisis caused by excess leverage by piling on more, not less, debt.”

There are aspects of the current global Bubble that are reminiscent of pre-2008 crisis – though the amount of debt these days is larger, price distortions greater and misperceptions more perilous. Then: “Washington will not allow a housing bust.” Now: Global central bankers will not allow market dislocation. Unprecedented market distortions – including Trillions of mispriced “AAA” debt securities – back in 2008 look pee-wee when compared to today’s fiasco in perceived money-like instruments (fixed-income as well as equities)

At the same time, today’s “tech” party is more 1999 – just so much more expansive. Loose “money” coupled with government/central bank backstops have nurtured another epic sector mania – replete with more dangerous regional economic and housing Bubbles. Today’s EM backdrop has uncomfortable characteristics reminiscent of 1996, with the current “hot money” onslaught compounding already acute financial, economic, social and geopolitical fragilities from Asia to Eastern Europe to Latin America.

And there are elements of fixed-income excess that recall all the way back to 1993. The proliferation of leveraged derivatives strategies cultivates latent fragility. Meanwhile, the scope of flows into fixed-income ETFs at this late stage of the cycle is astonishing – yet, as they say, “par for the course.” It’s consistent with the flood of funds into passive U.S. equities indices and the emerging markets; the near-panic buying of European and U.S. corporate debt – the tsunami of “money” inundating virtually all risk assets via the ballooning ETF complex.

What most sets today’s Granddaddy of All Bubbles apart? Historic excess and distortion throughout the securities and derivatives markets – and asset markets more generally – on an unprecedented synchronized, systemic global scale. It’s become myriad powerful booms all packed into one killer Bubble unlike the world has ever experienced. History will not be kind to central banker fixation on arbitrary 2% annual CPI targets. Nasdaq inflated 2.2% in Friday’s session – the Nasdaq100 2.9%!

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