Forever Blowing Bubbles, But Sometimes They Pop
"One thing is certain, that at particular times a great deal of stupid people have a great deal of stupid money . . . At intervals, from causes which are not to the present purpose, the money of these people—the blind capital, as we call it, of the country—is particularly large and craving; it seeks for someone to devour it, and there is a 'plethora'; it finds someone, and there is 'speculation'; it is devoured, and there is 'panic'." — Walter Bagehot (1826-1877) in “Essay on Edward Gibbon”
Good things are not coming. Happy days aren’t here again.
Look at Chart 1, a monthly chart of the Dow Jones Industrial Average for the last 20 years. Since 1997 it has traced out an enormous head and shoulders, or, more accurately, a broadening top.
The target for the fall is so low I feel ridiculous publishing it, but that’s what the standard measuring tool arrives at. The head measures 7,768 points. When a market falls out of this formation, it will roughly fall the height of the head subtracted from the bottom of the formation. Well, 6,500 less 7,698 equals minus 1198 points.
While I don’t expect to see stocks utterly collapse in value, the signpost stands there, pointing—down.
Stocks are in for a rough time on another score—they’re reaching the top of a 300 year expansion cycle. Although joint stock companies probably began with the Dutch East India Company in 1602, the first stock market bubble to grip an entire nation was the Mississippi Bubble in France from 1717 to 1720. The Scottish adventurer and spiritual ancestor of every inflationist, John Law, managed to generate a frenzied speculative bubble in shares of every kind, floating on a wave of newly issued money. (Lo, there is no new thing under the sun.) Inspired no doubt by Law’s fleeting success, directors of the South Sea Company in England—with government help—managed to blow up a bubble there, too. Interesting that even in those days long before globalism, bubbles propagated across national boundaries and savage country after country.
The point is that stock markets have been growing and rising for the last 300 years, and it seems that gigantic broadening top signals that a correction many years long is about to begin. (You can read about these bubbles and others in John Mackay’s indispensable 1841 book, Extraordinary Popular Delusions and the Madness of Crowds.
THE CONNECTION NEVER MADE
The connection that the public never seems able to make—or remember—is that all bubbles depends on a steady stream of newly created money. Just as the Mississippi Bubble needed John Law, so the Great Depression in the US needed a decade of inflation before hand, and so the Great Rally of Stocks since October 2012 (and 2009) has depended on Bernanke’s obliging money creation.
What terrifies me is that adults are no longer running the Federal Reserve. Since Greenspan’s stock market “rescue” in 1987, the Fed has lurched from bubble to bubble, creating a new bubble trying to deal with the explosion of the last. Thus Greenspan’s money machine blew up the stock market bubble that burst in 2000, and then he inflated the real estate bubble. Now in the wreckage of the real estate bubble, Bernanke has created a bond bubble AND a stock market bubble.
Good work, fellows. You are capital wreckers.
In economic and financial crises, the Fed and the government have only two weapons: liquidity and blarney. In acute crises they fire the blarney cannon when Obama, Bernanke, Warren Buffett, and an assortment of economists wearing coke bottle bottom glasses appear on TV intoning that “the economy is basically sound and should turn up from here.” Blarney, pure blarney, aimed at soothing the inflamed and frightened masses.
Liquidity means pouring money into the system, and liquidity—inflation—is the Fed’s only weapon. Whether it manipulates interest rates or buys assets, it can only inflate because deflation would kill the entire system. Besides, look at Bernanke’s play book, his November 2002 speech about what measures he would take in the face of deflationary conditions. He believes that the Great Depression was caused by a lack of inflation, so he has been steadily firing his inflationary machine gun, to wit:
- Zero Interest Rate Policy (ZIRP), announced 16 December 2008 later confirmed by FOMC “at least through 2015.” Arguably this is the worst part of Bernanke’s program, since it cripples pension funds who depend on a 5 to 8% return to pay their obligations, and it misdirects capital into government bonds and, now, into a stock market bubble.
Worse yet, the Zero Interest Rate Policy has created a bubble in bonds.
Nor does the Fed control all interest rates, never mind their propaganda. It sets a target Fed Funds rate, but doesn’t even control that. The Fed Funds rate is the rate that banks borrow from each other reserves on Deposit with the Federal Reserve. Trying keep the Fed Funds rate at its target, the Federal Open Market Committee buys or sells government bonds on the open market to influence short term interest rates.
Don’t miss the point here: the market, not the Fed, controls rates. And when the market wants higher rates, it will get them. Down below I will show you some charts of the 30 year Treasury bond and its yield to show what I mean.
- Quantitative Easing 1 (QE1) from November 2008 thru June 2010, bought $600 billion of Mortgage Backed Securities (MBS) $600 billion, and with treasury notes and bank debt, about $1.2 trillion total. Remember, when the Fed buys any asset, it creates high-powered money to do so, money that becomes the fuel for commercial banks’ inflating.
- Quantitative Easing 2 (QE2) November 2010 thru June 2011, about $600 billion in Treasury Securities
- Quantitative Easing 3 (QE3) 13 September 2012, no limit announced. QE-Infinity, buying $40 bn/month ($480 bn/year) in Agency MBS in addition to buying $45 month already for Operation Twist to keep interest rates at zero. Extended 12 December 2012 to maintain $85 bn/month ($1.02 trillion/year) level by extending $45 billion purchases of longer term US Treasury securities.
Yet all this has not brought the ecoomy back to life, except in the optimistic forecasts of the Federal Reserve. All the same, the Fed continues to inflate, smug for the moment that the money creation (“inflation”) hasn’t shown up too badly in consumer prices. Conveniently, they applaud the other inflationary outcome, rising asset (stock) prices.
US GOVERNMENT SPENDING
Here are some US government financial figures for Fiscal Year 2013 from usdebtclock.org.
- US Fed tax revenue, $2.723 trillion
- US Federal spending $3.535 trillion (130% of revenue)
- US Federal budget deficit. $811 billion (30% of revenue)
- US government debt 16.881 trillion (620% of revenue). Up 77% since 2008.
- Net interest on debt, $223 billion 6% of total spending, 8% of revenue
- Ratio of Federal debt to Gross Domestic Product, 107%
Of course, none of these numbers include the vast unfunded liabilities of the United States government, another $125 trillion according to usdebtclock.org.
The Eurozone claims it has a 92.2% debt to GDP ratio as of 22 July 2013. Japan’s is one of the world’s worst, approaching 250%.
There’s no place to hide.
WE DON’T OWE IT TO OURSELVES
In response to critics who pointed out how much his government spending was raising the national debt, Franklin Roosevelt famously shrugged it off with the not-so-brilliant comeback, “We owe it to ourselves!”
No, we don’t. Foreigners own a third of it. Besides, as the interest rate burden of the debt grows, government must either raise taxes or cut government spending to meet it. Increased taxes drag on the economy, which in turn lowers tax revenue. Eventually, the magic moment of terrified recognition comes when investors lose faith in the government’s bonds. Interest rates soar, the currency falls, and eventually the government must face default on its debt.
By the way, the US can never “grow its way” out of debt. The debt is too big to be repaid ever.
WHY THE US CAN’T FIX ITS BUDGET:
Back in October 2010 Moneychanger I published an examination of where GDP arises in the 15 Southern states. This may differ slightly from other states, but most are about the same. About 52% of income as measured by Gross Domestic Product arises out of government spending—about 20% state and local government, about 30% direct federal government. If you add to direct federal government spending all the loans, loan guarantees, and insurance, it bumps that Direct Federal Spending up to about 47% of state GDP. And since the Federal government has taken on so much more debt in its misguided attempt to jumpstart the economy, those percentages are higher now. (If the Federal government were a towing service, it would have melted its jumper cables by now.)
Listen: over half the income in the United States arises from government spending. And every special interest that benefits from that spending, from Social Security pensioners to defense contractors, will fight like screaming banshees to protect their place at the government teat. There is presently no politician on the national stage who will stand up to them, because he owes his election to those special interests. Therefore, “austerity” or budget cutting is out of the question. Spending can only grow, not be trimmed. It’s a one-way street: federal government spending, federal government debt, and the interest burden on that debt, can only grow.
Worse yet, with Obamacare coming on line, federal government spending can only grow more.
Sooner or later, and probably sooner, the debt burden becomes so great that the government cannot find buyers for its debt, because the threat of default is so great.
DEFAULT IS INEVITABLE
Don’t kid yourself: the federal government will default on its debt.
It will default in one of two ways, either by defaulting outright with some sort of re-structuring (creditors get a dime on the dollar and the debt’s term is extended) or by defaulting by inflation. Outright default would clear the stage for returning to fiscal sanity, but it won’t happen. On the other hand, the value of the debt is cheapened by continuing to inflate the dollar, and the interest burden is lightened by stifling interest rates.
(In fact, the federal government is already defaulting on its debt through inflation. Even by understated US government figures, if you loaned the US government $100 in 2000, you need $133.33 today to make good the inflation loss. They are repaying you only 75% of the value you loaned them 13 years ago. So it’s not a question of whether the government will default, but whether they will default faster by falling into a hyperinflation.)
The federal government faces a tightening noose:
- Spending can’t be cut, other than cosmetically
- Deficits are 30% to 50% of revenue
- Debt must grow to accommodate deficits. Total Federal debt has grown 77% since 2008.
- As the debt grows, the interest rate burden grows. If interest rates rise one percentage point on a $17 trillion debt, interest costs rise $170 billion.
- The Federal government relies more and more on foreigners to buy its debt. Beginning in 2000, foreigners (including, of course, foreign central banks) held 18.8% of the federal debt. At the end of First Quarter 2013, they held 34.3%, roughly twice as much. (Of course, there was lots more debt to go around, too.)
- The Federal Reserve itself is buying a greater percentage of Federal Government debt. John Williams comments,
“Since the implementation in January 2013 of the Federal Reserve’s expanded quantitative easing QE3, the Fed has continued to buy U.S. Treasury securities at a pace suggestive[ing] concerns that the U.S. government otherwise might have some trouble in selling its debt. From the beginning of 2013 through July 3, 2013, the Fed’s net purchases of Treasury securities have absorbed 90.5% of the coincident net issuance of gross federal debt. From the beginning of 2013 through July 3, 2013, the Fed’s net purchases of Treasury securities has absorbed 90.5% of the coincident net issuance of gross federal debt."(shadowstats.com, commentary No. 540, 8 July 2013)
So what? The mechanism for the 1920-1923 German hyperinflation was the central bank directly monetizing government debt, i.e., buying all the debt directly from the government. In the US the debt has always been sold through dealers, but the Fed’s Treasury bond buying operations make it look more and more like the buyer of last resort. If so, that’s a one-way ticket to hyperinflation.
- [Finally, no matter what he says, Ben can’t “taper.” Why not? Because since September 2008 he has multiplied the Fed’s Balance sheet 523%, from $0.675 trillion to $3.531 trillion. On June 19 we saw what the mere hint of tapering, even contingent on economic improvement knocked down stocks 4.3% in three days. In the face of a weak economy, the Fed can’t even stop buying bonds (“creating more money”), let alone decrease the money supply by selling bonds and trimming its balance sheet.
Take a look at the Fed’s Increases in its balance sheet compared to the timing of the S&P500.
BERNANKE’S BOND BUBBLE
To keep long term interest rates artificially low, Bernanke has had to buy US Treasury bonds with longer term maturities, i.e., the 30 year US Treasury bond. Remember that the price of bonds moves opposite to the yield or interest rate. When bond prices rise, interest rates fall. When bond prices fall, interest rates rise. That’s not theory, its mathematical nature.
Bonds have been a bull market for the last thirty years. Notice that’s a very long time for a primary trend to run. In other words, bonds are a very mature market. See chart 7, 30 year US Treasury Bond Price since 1980.
One has to suspect that interest rates have been unreasonably low most of that time, but notice the period from about 2008 forward, where the bond price really begins rising. Look at Chart 6, US Treasury Bond Price since 2008. That’s Bernanke’s ZIRP kicking in. Bernanke shaved interest rates down so low that it no longer made sense for investors to do anything but loan money to the US government. After all, US government securities are defined as the supposedly “lowest risk” asset. If interest rates on other loans weren’t paying enough to justify the risks of loaning money, then what can money do but buy US government debt. So into this mature primary trend, Bernanke herded and prodded millions more investors.
(The Zero Interest Rate Policy itself is pure lunacy. The Fed should step out of the way and let rates rise as high as the market wants them. By keeping rates artificially low and paying banks interest to hold reserves, Bernanke has created an artificial shortage of credit. Banks have the money, but why lend it and take the risk when you can hold reserves or buy Federal government bonds without any risk?)
DOES THE FED CONTROL INTEREST RATES
I argued above that the Federal Reserve doesn’t really control interest rates. Rather they attempt to influence rates through the Fed Funds rate, and now, by Operation Twist buying longer term maturities, sending up their price and sending down the long term interest rate.
Look at Chart 7, ZIRP CRUMBLES. The yield on the 30 year T-Bond bottomed in July 2012, and has risen ever since.
At end-December 2012 it pierced resistance around 30 (3.00%), traded up into March, came back, and tested support, then climbed again and broke out of the trading channel in June. The yield is moving higher, ZIRP or no ZIRP.
Question is, how high will it have to rise to send money fleeing from US government Treasury securities? I don’t know, but the ingredients of a government induced bubble—overpricing and near-universal ownership and opinion—are all in place. The Fed has led everyone to belief that US Treasuries will be a safe haven forever.
Whoops. If everybody owns them, when everybody wants to sell them, who will buy?
What might set it off? Anything. Watch for the signs: suddenly rising US government security yields, plunging bond prices, or a tumbling US dollar.
High on the horizon is the congressional fight on the debt limit, coming back on September 30. The government has paying its bills under a continuing resolution since May, when it hit the debt limit. Maybe this time the politicians will push the issue too far, and break public confidence in the US Government’s ability and willingness to pay its debts.
Or maybe overseas investors decide they need to trim their US government treasury securities.
Or a self-reinforcing cycle of rising interest rates, dropping bond prices, and a falling dollar work together to panic the market and throw the banks into another crisis.Whatever the trigger might be, the potential for devastation staggers even me, and I’m already no fan of the US dollar, Federal Reserve, or government. The market for US government bonds is one of the world’s largest financial markets; the dollar is the world’s reserve currency. A stampede out of either would wreck the world’s economy for a long time.
All courtesy of the wonderful, amazing Federal Reserve System, installed 100 years ago with the promise of bringing stability to the financial world.
How do you protect yourself against a cascading bond market? The only way I know is to hold assets whose value isn’t determined within that system: gold and silver.
Originally published July 2013