Easy Money Is Again Leading To Bubbles – Courtesy Of Central Banks

In this week’s commentary, John Mauldin looks at two highly relevant concepts: easy money (call it QE, money printing, helicopter money, or whatever the term) and economic bubbles (based on his latest book, Code Red, which he launched last week). Obviously the two are linked to each other. Although in the minds of central bankers there is not necessarily a direct effect between both, we simple human beings all know that the inherent risks are huge. You would not be reading this article if you believed otherwise.

We know that this is going to end badly, as explained in We Created The Conditions For Catastrophic Failure and in 2013 – Start of Seismic Shifts in Money, Metals, Markets (among many other articles).

They key in the thinking of central banks is that policy makers believe they can “manage” the effects of their monetary policies. It is somehow comparable with driving a car; even in a risky situation, the driver can adjust the rest of the drive to get back home safely. This assumes they can somehow decide on the driving conditions, even if the remainder of the trip is on an ice road. This “blindness” is reflected in the first chart of Mauldin’s article.

Toby Nangle, of Threadneedle Investments found the following chart, created a few years ago at the Bank of England. In looking at the chart, pay attention to the red line, which depicts real asset prices. As in they know they are creating a bubble in asset prices and are very aware of how it ends and proceed full speed ahead anyway. Toby remarks: “This is the only chart that I’ve found that outlines how an instigator of QE believes QE’s end will impact asset prices. The Bank of England published it in Q3 2011, and it tells the story of their expectation that while QE was in operation there would be a massive rise in real asset prices, but that this would dissipate and unwind over time, starting at the point at which the asset purchases were complete.”

QE_managed_2013

This is the most interesting chart we have seen in a while. Mind how the world works from the eyes from central planners. They truly believe they can exponentially inflate something and then manage it back to normal levels. So here is the question: what if things do not work that way in the real world?

Anyway, two other bubble signs that were spotted by Mauldin:

This is from my friend Doug Kass, who wrote: “I will address the issue of a stock market bubble next week, but here is a tease and fascinating piece of data: Since 1990, the P/E multiple of the S&P 500 has appreciated by about 2% a year; in 2013, the S&P’s P/E has increased by 18%!”

Continuing with our puckish thoughts, we look at stock market total margin debt (courtesy of Motley Fool). They wonder if, possibly, maybe, conceivably, perchance this is a warning sign? And we won’t even go into the long list of stocks that are selling for large multiples, not of earnings but of SALES. As in dotcom-era valuations.

securities_total_margin_debt_2013

Easy Money Will Lead to Bubbles

The causal effect between easy money and economic bubbles is so intuitive that one could ask the question who in this world is not able to see it. After all, wasn’t it the monetary policy of the US Central Bank who paved the way for the housing bubble which catastrophically popped in 2008? Shouldn’t we have learned meantime what the risks are of market interventions? Look at this video from Peter Schiff to learn the ivory tower in which central banking policy makers are living.

John Mauldin puts easy money in some recent context:

Central banks are trying to make stock prices and house prices go up, but much like the winners of the 2009 Darwin Awards, they will likely get a lot more bang for their buck than they bargained for. All Code Red tools are intended to generate spillovers to other financial markets. For example, quantitative easing (QE) and large-scale asset purchases (LSAPs) are meant to boost stock prices and weaken the dollar, lower bonds yields, and chase investors into higher-risk assets. Central bankers hope they can find the right amount of dynamite to blow open the bank doors, but it is highly unlikely that they’ll be able to find just the right amount of money printing, interest rate manipulation, and currency debasement to not damage anything but the doors. We’ll likely see more booms and busts in all sorts of markets because of the Code Red policies of central banks, just as we have in the past. They don’t seem to learn the right lessons.

Targeting stock prices is par for the course in a Code Red world. Officially, the Fed receives its marching orders from Congress and has a dual mandate: stable prices and high employment. But in the past few years, by embarking on Code Red policies, Bernanke and his colleagues have unilaterally added a third mandate: higher stock prices. The chairman himself pointed out that stock markets had risen strongly since he signaled the Fed would likely do more QE during a speech in Jackson Hole, Wyoming, in 2010. “I do think that our policies have contributed to a stronger stock market, just as they did in March of 2009, when we did the last iteration [of QE]. The S&P 500 is up about 20 percent plus and the Russell 2000 is up 30 percent plus.” It is not hard to see why stock markets rally when investors believe the most powerful central banker in the world wants to print money and see stock markets go up.

Properly reflected on, this is staggering in its implications. A supposedly neutral central bank has decided that it can engineer a recovery by inflating asset prices. The objective is to create a “wealth effect” that will make those who invest in stocks feel wealthier and then decide to spend money and invest in new projects. This will eventually be felt throughout the economy. This “trickle-down” monetary policy has been successful in creating wealth for those who were already rich (and for the banks and investment management firms who service them) but has been spectacularly a failure in creating good jobs and a high-growth economy. The latest quarter as we write this letter will be in the 1 percent gross domestic product (GDP) range.

And to listen to the speeches from the majority of members of the Federal Reserve Open Market Committee, their prescription is more of the same. Indeed, when Bernanke merely hinted this summer that QE might end at some point, something that everyone already knows, the market swooned and a half-a-dozen of his fellow committee members felt compelled to issue statements and speeches the next week, saying, “Not really, guys, we really are going to keep it up for a bit longer.”

Excessive Monetary Liquidity Creates Bubbles

Mauldin explains that the corporate bond market is looking particularly bubbly. He says: “Investors are barely being compensated for the risks they’re taking. In 2007, a three-month certificate of deposit yielded more than junk bonds do today. Average yields on investment-grade debt worldwide dropped to a record low 2.45 percent as we write this from 3.4 percent a year ago, according to Bank of America Merrill Lynch’s Global Corporate Index. Veteran investors in high-yield bonds and bank debt see a bubble forming. Wilbur L. Ross Jr., chairman and CEO of WL Ross & Co. has pointed to a “ticking time bomb” in the debt markets. Ross noted that one third of first-time issuers had CCC or lower credit ratings and in the past year more than 60 percent of the high-yield bonds were refinancings. None of the capital was to be used for expansion or working capital, just refinancing balance sheets.”

Now here is the key which all of us understand intuitively:

One day, all the debt will come due, and it will end with a bang. “We are building a bigger time bomb” with $500 billion a year in debt coming due between 2018 and 2020, at a point in time when the bonds might not be able to be refinanced as easily as they are today, Mr. Ross said. Government bonds are not even safe because if they revert to the average yield seen between 2000 and 2010, ten year treasuries would be down 23 percent. “If there is so much downside risk in normal treasuries,” riskier high yield is even more mispriced, Mr. Ross said. “We may look back and say the real bubble is debt.”

As we have re-iterated several times, debt is the biggest bubble.

bond_bubble_2013

Mauldin goes on to explain that agricultural is another bubble which is developing in many places in the United States although agriculture in other countries can be found at compelling values.

Why are we seeing so many bubbles right now? One reason is that the economy is weak and inflation is low. The growth in the money supply doesn’t go to driving up prices for goods like toothpaste, haircuts, or cars. It goes to drive up prices of real estate, bonds, and stocks.

Excess liquidity is money created beyond what the real economy needs. In technical terms, Marshallian K is the difference between growth in the money supply and nominal GDP. The measure is the surplus of money that is not absorbed by the real economy. When the money supply is growing faster than nominal GDP, then excess liquidity tends to flow to financial assets. However, if the money supply is growing more slowly than nominal GDP, then the real economy absorbs more available liquidity. That’s one reason why stocks go up so much when the economy is weak but the money supply is rising.

Finally, looking at the history of economic activity, it appears that boom and bust are going hand in hand in a centrally planned monetary world. Excess liquidity finds its way in the economy and affects asset prices in a way that is (a) unavoidable and (b) hard or impossible to turn back. That is the key to boom and bust.

It is also why stock markets are so sensitive to any hint that the Fed might ease off on QE. Real players know how the game is played. You can listen to the business media or read the papers and find hundreds of “experts” saying that stock prices are rising based on fundamentals. You can take their talking points and change the dates and find they are essentially the same as 1999 and 2006–2007. The rise in real estate, bonds, and stocks does not count toward any inflation measures. Excess liquidity flows from asset class to asset class. As you can see from Figure 9.3, booms and busts around the world happen whenever central banks tighten or loosen monetary policy.

booms_busts_1965_2013

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