'Our nation (and the world) was profoundly scarred by the Great Depression experience. At the time, it was recognized that years of Bubble excess had fostered deep economic structural maladjustment. The Credit system had degenerated into a mechanism promoting epic asset inflation, mal-investment and chicanery. The securities markets devolved into a bastion of speculation, with destructive end-of-cycle excesses (1927-1929) placing the system in great peril. Boomtime Federal Reserve monetary management was an abject failure. And, especially late in the cycle, resources – real and financial – could not have been more poorly (or inequitably) allocated. Years of accelerating Credit and speculative excess – and attendant Monetary Disorder - ensured hopelessly over-levered and dysfunctional Bubble markets.'Issues 2022By Doug Noland
January 8, 2022
SourceIssue (singular) 2022. Is “money” (monetary inflation) more the solution or the problem? For a number of years now, I’ve highlighted in my January “Issues” pieces the Credit Bubble Maxim: “The Bubble Either Further Inflates or Bursts.” As I detailed in “2021 Year in Review,” last year’s Bubble inflation went to perilous extremes. This significantly raised the odds for a destabilizing 2022 bursting episode.
November 29 – Financial Times (Mary O’Sullivan): “In a celebrated book published in 1963, Milton Friedman and Anna Schwartz constructed a counterfactual history in which the Great Depression did not have to take place in the United States in the 1930s. They imagined an alternative world in which there was no collapse in production, no spiralling deflation, no mass unemployment and no poverty. It was a world, they claimed, in which an ordinary recession might have occurred but not a depression. And one that could have been part of our history if only America’s central bankers had flooded liquidity into the financial system to avert its collapse… Friedman’s work with Schwartz proved decisive in sustaining the claim that in the 1930s the US Federal Reserve had exercised its monetary responsibility ‘so ineptly as to convert what otherwise would have been a moderate contraction into a major catastrophe’. The alternative world that Friedman and Schwartz imagined proved so alluring that their interpretation had become the orthodoxy of the Great Depression in the US by the end of the 20th century.”Our nation (and the world) was profoundly scarred by the Great Depression experience. At the time, it was recognized that years of Bubble excess had fostered deep economic structural maladjustment. The Credit system had degenerated into a mechanism promoting epic asset inflation, mal-investment and chicanery. The securities markets devolved into a bastion of speculation, with destructive end-of-cycle excesses (1927-1929) placing the system in great peril. Boomtime Federal Reserve monetary management was an abject failure. And, especially late in the cycle, resources – real and financial – could not have been more poorly (or inequitably) allocated. Years of accelerating Credit and speculative excess – and attendant Monetary Disorder - ensured hopelessly over-levered and dysfunctional Bubble markets.
Milton Friedman and Anna Schwartz couldn’t accept that free market Capitalism had gone completely off the rails; that markets were not rationally self-regulating. Throughout their almost 900-page tome, discussion of the key topics Credit and Credit excess were curiously omitted. In portentous historical revisionism, they fashioned analysis that the Great Depression was not the upshot of boom-time excess, but rather the result of Federal Reserve negligence for not flooding the system with money after the 1929 crash and subsequent banking crisis. The “Roaring Twenties” were designated “the golden age of Capitalism.” Their fallacious thesis was eagerly accepted by an intelligentsia happy to button up the depression experience and move on.
More from the FT (Mary O’Sullivan):
“In 2002, Ben Bernanke offered a tribute to Friedman and Schwartz: ‘I would like to say to Milton and Anna: regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.’ The rest is history. The flood of liquidity that followed the financial crisis was remarkable when considered in historical perspective. And that was before central banks responded to the coronavirus crisis with even more spectacular injections of liquidity.”The trio Friedman, Schwartz and Bernanke converge for the greatest misadventure in central bank monetary doctrine the world has ever experienced. I’ve argued for years now that history’s greatest Bubble would end in catastrophe. In the meantime, however, it has appeared nothing short of the “Golden Age of Capitalism.” Last year’s monetary madness fueled “Roaring Twenties” redux.
I was worried in January 2008. Yet those disturbing mortgage finance Bubble excesses are today dwarfed by unparalleled levels of debt, speculative excess and economic maladjustment – at home and abroad. My 2008 concerns were mainly domestic – financial, economic and social. All three are today more deeply concerning. Moreover, with Bubbles having engulfed the world, wealth redistribution and inequities greatly heighten geopolitical risks.
History teaches that Credit is inherently unstable. It’s self-reinforcing, where excess begets only greater excess. It is morally and ethically fundamental that money and Credit remain well-anchored. This risk of losing control is potentially catastrophic.
The U.S. nineties’ adoption of “Wall Street” market-based finance (i.e. the GSEs, MBS, ABS, “repos”, derivatives, etc.) created highly unstable securities markets, along with unsound Credit more generally. Instability was conspicuous in 1994, 1998 and 2000-2002. Instead of tightening monetary policy and developing the regulatory framework to contain this unfettered Credit, monetary policy changed to accommodate the new financial structure. Rather than the 2008 debacle provoking a necessary major remake of financial structure and monetary management, it was far simpler to unleash overpowering monetary inflation.
I fear decades of mismanagement come home to roost in 2022. Friedman and Schwartz revisionism. Greenspan’s inflationism, manipulation and promotion of unchecked market-based finance. Bernanke’s deeply flawed inflationist doctrine – readily embraced by global policymakers. Yellen and Powell’s affirmation of monetary insanity.
The Fed’s balance sheet has inflated more than 10-fold since 2007. Repeatedly, monetary inflation was called upon to bolster increasingly unstable markets – to resuscitate Credit and speculative Bubbles. QE and “whatever it takes” central banking combined for the most powerful inflation of market wealth ever. And the bigger the Bubbles - and resulting fragility - the more intense the addiction to monetary excess. The pandemic created the necessary backdrop for the mobilization of $5.0 TN of additional Fed liquidity ($6.4TN, or 40%, M2 growth) in 120 weeks.
December CPI is forecast to exceed 7% for the first time in 40 years. The Powell Fed took a huge gamble on “transitory,” and its institutional credibility was the big loser. Suddenly, the Federal Reserve has lost the aura of competence and infallibility. Having escaped the confines of the asset markets, inflation is there for everyone to see and feel. The Fed’s whitewashing was an embarrassment. Now, the FOMC’s “manhood” is questioned. Time to stand tall and roll out some brawn.
QE is the nuclear option to be used only when necessary to thwart market collapse. If adopted, it should be methodically reversed soon after system stabilization. It should never be part of the policy tool kit to goose the markets, confidence and economic activity.
Last year’s Trillion plus liquidity injections in the face of manic markets was a dire policy blunder I’ll assume not lost on members of the FOMC. Markets this week were shaken by the Fed meeting minutes and talk of QT – “quantitative tightening” – or balance sheet reduction.
It’s wishful thinking on the part of the Fed, Wall Street or anyone to think that historic monetary inflation and associated market speculation can simply be tamed by a nudge higher in short-term rates and some liquidations of Fed Treasury/MBS holdings. Major Bubbles inflate or burst. Runaway Bubbles self-destruct – first to the upside and, then, implosion. Today’s mania faces the uncomfortable prospect of a Federal Reserve that’s actually ready to meaningfully tighten policy, so long as markets hold Bubble collapse at bay.
A few years back, I posited that the Fed’s balance sheet could reach $10 TN during the next crisis. That number needs to be ratcheted up to $15 TN. I had expected major Fed balance sheet expansion would be necessary to accommodate a bursting Bubble and historic speculative de-leveraging. Instead, the Fed in March 2020 reversed de-risking/deleveraging, with colossal QE instead spurring only more egregious speculative leverage (derivatives, Treasuries, fixed-income, equities, crypto, NFT, housing, etc.).
I doubt QT ever gets off the ground. If it does, expect grounding in short order. The odds favor a larger Fed balance sheet by year-end – perhaps much bigger. But today’s backdrop is unique in the “whatever it takes” open-ended QE era: inflation presents a clear and present danger. In a major problem for such highly inflated manic markets, the Fed will have to think twice before restarting the electronic printing press. Markets will have to be in some serious trouble before securing the tranquilizing effects of QE announcements. Expect liquidity injections to come, though perhaps too late for the equities Bubble.
In March 2020, rapidly deleveraging market Bubbles had the Fed hastily boosting QE commitments in increments of $500 billion until deleveraging subsided. For the next “risk off” episode, even $500 billion QE increments may prove insufficient, as an indecisive Fed keeps one eye on the markets and the other focused on troubling inflation data.
January 2 – Financial Times (Robin Wigglesworth): “In Steven Spielberg’s original Jurassic Park, the chaos theorist played by Jeff Goldblum chastises the theme park father’s folly in resurrecting dinosaurs by noting: ‘Your scientists were so preoccupied with whether or not they could, they didn’t stop to think if they should.’ The exchange traded fund industry should take note. This is a heady time for the ETF world. Overall inflows last year topped $1tn for the first time. Coupled with the buoyancy of financial markets, this means that the ETF industry is on the cusp of crossing the $10tn of assets under management mark… Bond ETFs took in about $244bn in 2021 — a new record and the third $200bn-plus year in a row.”Ten-year Treasury yields jumped 25 bps in the first week of the year, to an almost two-year high 1.76%. Five-year Treasury yields jumped 24 bps to a 23-month high 1.50%.
Amazingly, bond funds posted strong inflows this past week, adding to last year’s windfall. Bloomberg’s Jurassic Park analogy is a good one. ETF assets reaching almost $10 TN, having grown tremendously since the Fed’s March 2020 bailout. The “Moneyness of Credit” concept was key to my mortgage finance Bubble analytical framework. I shifted to the “Moneyness of Risk Assets” when Bernanke employed $1.0 TN of QE, collapsed rates, and coerced savers into the risk markets. The mushrooming ETF marketplace best exemplifies today’s distorted perception of safety and liquidity (“moneyness”), which has been fundamental to this cycle’s speculative blow-off – culminating with 2021’s spectacular mania.
Do rising market yields and mounting losses panic bond ETF holders, spurring market dislocation and a destabilizing yield spike? How much leverage has accumulated in the ETF universe and fixed-income markets more generally? Globally, in particular EM and China? Reflecting the challenging rate hedging backdrop, benchmark MBS yields surged 34 bps this week to 2.41%, the highest level since the chaotic March 2020 yield spike.
All hell broke loose back in February 1994, when the Fed belatedly commenced a tightening cycle after an extended period of market excess. “IOs,” “POs,” and myriad mortgage derivative products/strategies imploded, with de-leveraging stoking illiquidity and a self-reinforcing yield spike. The amount of debt, speculative leverage and derivatives these days makes 1994 excess appear trivial.
Never have the American people had such exposure to U.S. securities markets. The U.S. household sector (from the Z.1) ended Q3 with Total Equities exposure at 184% of GDP, dwarfing previous cycle peaks 104% from Q2 2007 and 115% back in Q1 2000. Who buys when the crowd moves to sell? Clearly, the leverage speculating community will seek to beat “retail” to the exits. Disorderly selling of ETF equities shares is a major risk, compounded by the extraordinary growth in options trading and derivatives hedging strategies. Who is on the other side of derivatives-related selling when sinking markets see the cascade of sell orders required to hedge market protection previously written/sold.
The KBW Bank index surged 10.1% this week, boosting one-year gains to almost 37%. The bullish narrative holds that rising rates will benefit banking system profitability. Japanese banks jumped 6.9%, with European banks this week rising 6.7%. No one is prepared for a global crisis.
China faces an extraordinarily challenging 2022. Developments point to a deepening developer crisis, expanding further into a collapsing apartment Bubble and broadening systemic crisis.
January 3 – Bloomberg: “A wall of maturing debt and a surge in seasonal demand for cash will test China’s financial markets this month, putting pressure on the central bank to ensure sufficient liquidity. Demand for liquidity may total about 4.5 trillion yuan ($708bn) in January, 18% more than the amount seen last year, according to calculations by Bloomberg based on official data and analysts’ estimates. An increase in the amount of policy loans coming due and demand for cash to be spent during the Lunar New Year… are drivers… ‘There are a number of factors that may pose threats in January to the stable liquidity conditions the central bank has vowed to maintain,’ said Yishuang Li, an analyst at Cinda Securities Ltd., citing tax payments and maturity of policy loans. ‘The bond market is currently vulnerable after an increase of leverage in December, which means financial institutions will be more reliant on PBOC’s liquidity support.’”
January 1 – Bloomberg (Olivia Tam and Sofia Horta e Costa): “China’s property developers have mounting bills to pay in January and shrinking options to raise necessary funds. The industry will need to find at least $197 billion to cover maturing bonds, coupons, trust products and deferred wages to millions of migrant workers, according to Bloomberg calculations and analyst estimates. Beijing has urged builders like China Evergrande Group to meet payrolls by month-end in order to avoid the risk of social unrest.”A crisis of confidence in China is a key Issue 2022. The perception that Beijing has the developer crisis under control is fading. Faith in the mighty Beijing “meritocracy” is in jeopardy. The Chinese people have persevered through a couple tough years. Beijing’s Covid “zero tolerance” has demanded personal sacrifice. Now Omicron risks exposing a highly vulnerable population (less effective vaccines and limited natural immunity). Omicron outbreaks, widespread lockdowns, mass infections and economic crisis are not a low probability scenario. Beijing risks the appearance of a misguided Covid policy failure.
January 7 – Bloomberg (Jinshan Hong): “Hong Kong is at a Covid-19 tipping point. The once-vibrant gateway to China sacrificed its status as an international hub to ‘Covid Zero,’ its strategy for eliminating the virus by isolating itself from a world awash in the pathogen. It worked for nearly a year, keeping residents safe and largely unfettered while raising the tantalizing possibility of reopening the border with China, the city’s economic lifeblood. Now it’s living with the worst of both worlds, after a couple of imported infections caused by the highly transmissible omicron variant started spreading in the under-vaccinated city, triggering renewed curbs. Residents can no longer go to the gym or the cinema, and the once-ubiquitous banquets where people gathered to celebrate the Chinese New Year were cancelled for another year. Also gone is the sense of security that stemmed from the city being virus-free…”China’s communist party has guided an unprecedented period of national growth and prosperity. They are credited with a historic boost to Chinese wealth, living standards and global standing. Leadership has been revered domestically for adept economic management. As such, there is today a vast chasm between the perception of unassailable competency and the reality of a catastrophic failure to rein in Credit and speculative excess. I expect 2022 to see this gap narrow, with the realization that China’s unsound Bubble economy is both fragile and faltering. If this realization comes concurrent with a destabilizing Omicron outbreak, the risk of a crisis of confidence (in policymaking, apartment markets, the economy and prospects) will rise exponentially.
January 4 – Financial Times (Sun Yu): “Chinese banks rushed to meet their annual state-imposed lending quotas last month by buying up low-risk financial instruments rather than issuing loans, a surge that bankers and analysts said reflected financial institutions’ wariness about the country’s slowing economy. The rise in demand for banker’s acceptance bills, which are guaranteed by their issuers and technically classified as loans, reduced the yield on the instruments to close to 0% in the second half of December, hitting a record low of 0.007% on December 23. That was far lower than Chinese banks’ average 2.5% cost of capital over the same period, implying that they preferred to lose money on low-yielding banker’s acceptance bills rather than risking greater losses by issuing their own loans… Loan officers said buying up banker’s acceptances to meet their year-end lending quotas was the safest way to back the government’s policy objectives. ‘Supporting the broader economy is a political task we can’t say ‘no’ to,’ said an executive at Zhongyuan Bank in…’Our losses from buying banker’s assurances are smaller than lending to unqualified businesses’… ‘The authorities want us to support the real economy while keeping bad debts under control,’ said a loan officer at Zheshang Bank... ‘That is difficult to achieve in the current business environment.’”“The authorities want us to support the real economy while keeping bad debts under control.” I pity the Chinese banker. Especially in the event of widespread lockdowns, Beijing will have little alternative than to inject large amounts of liquidity into the system. Not long ago they stated that policy would not go in this direction. Similar to other central banks, the People’s Bank of China risks stoking inflation. A confluence of sinking asset prices (apartments and securities) and rising consumer prices would pose quite a challenge to policymakers and the banking system. A surge in yields and currency instability would further cloud the soundness of China’s banking system. I don’t expect the ring-fence protecting the banking system from developer instability to hold through 2022.
I worry about China’s faltering Bubble and the ramifications for geopolitical risk. Fear that a domestic crisis could be a factor in a more belligerent approach with Taiwan doesn’t today sound so farfetched. That Putin placed 100,000 Russian troops at the Ukraine border concurrent with escalating China and Taiwan tensions leaves me apprehensive. With my view that 20[2]2 will be a pivotal year for the historic global Bubble, I’m on high alert for geopolitical developments.
I take no comfort in sounding like an extremist. When I started posting the CBB back in 1999, I promised readers to “call them as I see them and let the chips fall where they will.” This Bubble has inflated far longer and to much greater excess than I ever imagined possible. But it is undoubtedly a historic Bubble – and Bubbles know no cure. No amount of “money” will inflate out of this predicament. And pain on the downside will be proportional to the excess and duration of the preceding boom.
Late-cycle manic markets become increasingly dysfunctional. Fundamental factors are disregarded in favor of short-term speculative dynamics. Market turn incapable of self-adjustment. If the first week of the year is any indication, it’s destined to be a wildly unsettled year for financial markets. The Nasdaq100 sank 4.5%, and the Biotechs (BTK) dropped 5.7%. The NYSE Financial Index jumped 3.3% (Nasdaq Bank Index up 7.9%), and the Philadelphia Oil Service Sector Index surged 14.4%. Globally, the Shanghai Composite dropped 1.7% (ChiNext down 6.8%), while India’s Sensex jumped 2.6%. Stocks finished the week higher throughout Europe.
Here at home, the social mood continues to darken. The country seemingly couldn’t be more deeply divided. Trust in our government, our institutions, in each other – has withered. There is underlying angst and frustration. It’s as if the securities markets are an oasis of faith and confidence.
There’s never been so much riding on acutely unstable financial markets. It will be a pivot year. At the minimum, there will be extraordinary wealth redistribution. Tens of millions of unsuspecting online “investors” will be educated about risk the hard way. Odds are high of a series of bursting Bubbles – bonds, stocks, crypto, NFT, options trading, etc.
At some point this year, I expect a serious bout of de-risking/deleveraging. And I suspect Wall Street assumes that a market-based tightening of financial conditions would curtail inflation risk and open the Fed to dispensing another shot of liquid courage. I’m just not sure if market trouble initially translates into disinflationary forces, as in the past. November Consumer Credit surged a record $40 billion, double the median estimate. As sure as the morning sunrise, our federal government will borrow and spend with reckless abandon. At least for now, I expect strong growth in mortgage and business Credit. In short, the economy has attained such strong inflationary biases that even with some market deleveraging, there could still be ample system Credit growth to fuel rising consumer prices.
There’s a potential Issue 2022 worthy of a mention. It would be a very problematic development if the Fed responds to collapsing stock prices with large liquidity injections - and the Treasury market protests with a spike in bond yields. With inflation increasingly ingrained, a move by the bond market to discipline the Fed is not a totally wacky notion. At the minimum, I expect extreme policy, market and economic uncertainties to unleash wildly unstable currency markets. Currency values are relative – and the world is replete with fundamentally sick currencies. Destabilizing dollar and renminbi volatility is a distinct possibility.
There were 850,000 new Covid cases reported today. Over 130,000 Covid sufferers are currently hospitalized, rising with a trajectory to soon surpass the previous pandemic peak. Deaths are approaching 2,000 a day – with the one millionth U.S. Covid fatality likely in 2022. While Omicron symptoms are generally less severe, Covid has never enjoyed such transmissibility and freedom to infect in staggering numbers. While it should be a short-term phenomenon, there are troubling indications of worker shortages, expanding disruptions, and supply chain issues on multiple fronts. Already stretched global supply chains will face greater challenges as Omicron spreads through Asia and, at some point, China.
We’re living history. The backdrop could not simultaneously be more fascinating, intriguing and deeply troubling. I could be back this time next year again chanting, “Bubbles inflate or burst.” But I have high conviction it’s time to be prepared. “We are never prepared for what we expect” (James A. Michener). And as we begin 2022, never has a phrase seemed more germane: Let’s hope for the best, but prepare for the worst.
Context '..the current monetary system, based on credit expansion .. “manic-depressive” behavior..'[Thomas Hoenig] has a Dire Warning About Where We’re Headed - '..Household Expense Data .. for 80 Years'(Banking Reform) - "El-Erian Says ‘Transitory’ Was the ‘Worst Inflation Call in the History’ of the Fed."('The "Manic-Depressive" Economy) - 'It’s turning into a debacle..'(August, 2021) - '..we’ve reached the most extreme valuations in the history of the U.S. financial markets..''.."financial slavery" that grips the world .. are of high human and personal cost..''..the disconnect between Wall Street and Main Street .. unsound money is incompatible with social and political stability.'(Banking Reform - English/Dutch) '..a truly stable financial and monetary system for the twenty-first century..'