The US economy is sitting on a gigantic bubble and it is only a matter of time before disaster strikes. There’s no light at the end of the tunnel.
Nearly a decade after Ben Bernanke, then chairman of the US Federal Reserve, announcing Quantitative Easing (QE) in 2008, we are close to the beginning of the reversal of the QE programme. The Fed under Janet Yellen has communicated along these lines and this narrative has been largely taken at face value by the markets.
To remind readers, the QE programme, which was started as a response to the 2008 credit crisis, happened in three distinct phases from 2008 to 2014. The combined effect of QE 1, 2 and 3 caused the US Fed’s balance sheet to expand from $900 billion to more than $4.5 trillion. A large part of this expansion happened through the US Fed directly buying US treasury bonds. But, there was also a substantial purchase of the very illiquid mortgage-backed securities assets (I doubt if one can use that term “asset” in the real sense of the word in this situation though).
Since the last tranche of QE3 that happened under ZIRP (Zero Interest Rate Policy), the Fed has actually raised rates to 1.25 points (after an unprecedented seven years at “0” per cent from December 2008 to December 2015), and most analysts believe that it will continue the normalisation programme of interest rates well into 2018. Some of the internal forecasts within the Fed, such as of San Francisco Fed President John Williams, are that the Fed is on path for 3 per cent by 2019.
As Yellen outlined, this Quantitative Tightening (QT1) would start with selling $10 billion a month and would be increased to $50 billion, depending on market conditions. Though the Fed has indicated that it could revert to an easing mode if warranted, the consensus is that the QT programme would run its course at least for the next one or two years.
As I will explain below, the consensus on both the rates being normalised, as well as the QT running its course as scheduled, is dead wrong. Not only will the US Fed abandon QT1 midway, but it will be replaced by QE4. And that QE4 would not be the last of the QE series and we have miles to go in that direction.
The Almost Everything Bubble Economy
The US equities, housing and bond markets are one gigantic bubble that the Fed has inflated over the last several decades through its “easy money” policies. This process of opening the monetary spigots at every sign of trouble essentially started with former Fed boss Alan Greenspan, but his successors, Bernanke and Yellen continued, in much the same vein. The next in line, Jerome Powell, promises more of the same.
The Stock Market Bubble: The S&P 500 has more than doubled in the last five years from about 1200+ to about 2600 now. But the earnings over the entire trajectory have hardly recorded any growth at all. The earnings peak coincided, perhaps not coincidentally, with QE3 ending in October 2014.
Even if one were to dismiss the last five years as too short for analysis, the S&P earnings from 2007 to 2017 have hardly recorded any meaningful growth — from a generally accepted accounting principles (GAAP)-adjusted EPS (earnings per share) of 85+ in 2007 to less than 100 expected for 2018. That’s cumulatively less than a 20 per cent non-inflation-adjusted growth over a 10-year period. The entire growth in stock markets has happened because of a P/E expansion caused by low interest rates and QEs.
Housing Bubble 2.0: The Case-Shiller Index which represents the level of housing prices in the US now trades well above the levels set at the peak of the housing bubble in 2007. Through a combination of easy money and targeted Fed purchases of distressed assets, the Fed has managed to blow back air into a burst housing bubble 1.0 in fairly short order.
But there are some differences between the two bubbles. Instead of the average Joe taking out NINJA (No Incomes, No Jobs and No Assets) loans, it’s the private equity (PE) funds speculating with the proceeds of QE on housing markets. So, we have a situation where housing inventory is still high vis-à-vis the previous bubble and the recovery has primarily been in “housing prices” and not necessarily “housing markets”. This bubble financing necessitates a continuous flow of funds to maintain the illusion of a recovery.
QT will have exactly the opposite effect and 2018 could well be a repeat of 2008 for housing prices.
The Bond Market: Virtually underwriting the equity and the housing bubbles is a substantially bigger, but much less understood bubble — the bond bubble. It’s easy to understand equity bubble valuations through the P/E vis-à-vis growth projections, and similarly in the case of the housing bubble through rental yields or median incomes. A bond bubble is much harder to fathom, given that the links to fundamentals, such as fiscal deficits, unfunded liabilities are much more tenuous in nature and have been seemingly non-functional/broken for a couple of decades now. The endangered species of bond vigilantes is now almost extinct.
So, even sophisticated investors do not comprehend the extent of the bond bubble. But fundamentals that the markets have seemingly ignored for the last couple of decades will make a comeback and when Mr Market demands the right price for bonds, the casualty would be the “American way of life” that the US citizens take for granted.
Given the size and duration over which these have been built up, the US government can, in no way, afford an unravelling of these bubbles. At least, not at the current levels of debt and unfunded liabilities within the system.
Then of course, we have Mr Market who will, in no way, allow these bubbles to continue for an extended period of time.
As I see it, there can be no orderly unwinding of these bubbles and the decade ahead promises to be a tumultuous one in whatever direction it plays out.
US Fed Vs. Mr Market
The essential point that the reader has to understand is that unless these imbalances are addressed, the US economy cannot return to a meaningful growth path in the foreseeable future. It can only meander through the boom-bust cycles as it has been doing for the last decade and a half with each successive bubble being bigger than the previous one.
There are only two ways in which these malinvestments can be corrected for a reallocation of capital, i.e. through a market-driven deflationary recession or through a US Fed-led inflationary/ hyper-inflationary depression. There is no middle ground to tread here.
Market Induced: Mr Market will push for a deflationary collapse of these bubbles as we witnessed in 2008 and one that was temporarily backstopped by the US Fed using the QE route. With a decade of near 0 per cent interest rates and QEs on top of that, the malinvestments are far worse than was the case prior to the 2008 crisis. When the inevitable correction sets in, we will witness extensive write-downs on equity, housing, bond portfolios and all of those assumed benefits of social security and medicare have to be foregone. But the saving grace would be that the US dollar will retain a semblance of its value. This is what happened during the Great Depression of the 1930s.
Most market observers believe that the 1930s depression was caused by deflation. This is essentially a revisionist version propogated by the US Fed as a cover for the subsequent decades of inflation. While this is not the correct place to explain what led to the Depression and how the US government made it worse with the interventions, I would point to The Great Depression by Murray Rothbard for the real facts of the case.
While on the topic of deflation, I should also point out that the entire 19th century in the US was deflationary and that the US economy grew at a nominal 4 per cent+ rate during this whole period. In fact, the transition of the US economy from a backward agrarian society to an industrial powerhouse that housed almost 90 per cent of the world’s productive assets, happened under a deflationary condition and without a central bank (for most parts). So much for the extraordinarily popular delusion that deflation is bad for the economy or for that matter, that a central bank is necessary for an advanced society.
While a deflationary burst would be the least undesirable outcome for US citizens as well as most corporations, it would exactly be the least desirable outcome as far as the US government is concerned. As the most indebted participant in the economy, a deflation is something that the US government (for that matter, most governments around the world) cannot withstand.
The Fed / US Government Induced: We have seen this script play out too many times. I do not want to second-guess the sequence of events. While the QT programme begins and the US economy has a whiff of deflation, the US Fed will abandon the entire QT exercise and launch QE4. I suspect QT would run through the first quarter or two of 2018 before we witness QE4.
While QE1, 2 and 3 happened under conditions of falling money velocity (in part due to the below-the-surface recession in the US economy and deliberate suppression of gold prices orchestrated by the US Fed/Bank of International Settlements), I suspect QE4 is going to have a markedly different outcome. There are plenty of reasons to believe that QE4 is going to be accompanied by higher interest rates, rapidly rising consumer prices and a dramatic decline in the purchasing power of the US dollar.
International conditions may also not be benign as was with the initial rounds of QE. China has plans lined up for launch of the gold backed petro-yuan as a replacement for the petro-dollar. So, lower gold prices do not necessarily suit the Chinese interests anymore. Additionally, the quantum of gold available today for accumulation is also substantially lower.
Domestically, having pushed for tax cuts as well as dramatic spending increases on the military as well as welfare, President Donald Trump needs a monetisation of these ever increasing deficits. In his Yellen-copy Jerome Powell, it’s certain that Trump has a very accommodative partner. So, it more or less looks certain that QE4 is in the works. The only uncertainty remains is the timing. As I suspect, it will not be too far off.
The Road Ahead for the US Fed
Why will the US Fed voluntarily produce an open ended QT pin to deflate these too-big-to-prick bubbles?
After an extraordinarily accommodative decade of low interest rates and QE, the US Fed had to begin the normalisation process to retain a semblance of monetary responsibility. With the doctored unemployment numbers at a sub 4.5 per cent level (the real unemployment numbers using the 1970s methodology as calculated by alternative economic analysis newsletter Shadow Statistics is well above 22 per cent) and stock markets at all-time highs, the traditonal excuses to continue the accommodative stance no longer exist.
That said, I am sure the Fed is aware of these issues and may not necessarily pursue both the QT and rate increase programme simultaneously. In whatever style and measure they undertake the tightening cycle, it is likely to be very short-lived.
Not a very bright forecast and there’s no light at the end of the tunnel, as I see it, for the US economy. In our own interest, what the Reserve Bank of India can do is to convert the soon-to-be-worth-a-lot-less US dollar holdings into gold, as well as to repatriate our leased gold.
The Indian government should also remove all custom duties on gold that unnecessarily impose a burden on the Indian saver. Surely, these steps will hasten the decline of the US dollar and the US economy. But then, as the German philosopher Nietzsche said, “That which is falling, deserves to be pushed”.