Doug Noland: No Exit Plan for the Central Banks

JIM: Joining me on the program today is Doug Noland. He’s senior portfolio manager at Federated.

And Doug, a pattern that we've seen come out in the 2008 crisis is beginning in 2010, we get the stimulus, which began in 2009 with the QE response; the economy begins to roll over as we head into the summer, then we get the Fed announcing, at Jackson Hole, QE2. Last year the economy began to roll over again as we headed into the fall, the Fed announces in September it’s leaving interest rates at zero to, you know, 2014; then he announces Operation Twist. So relate this to where we are today because it seems like there is more talk about more policy response in order to keep this market and the economy alive. It seems like we've really moved into a very unstable environment where it takes all of this kind of intervention and I’m not sure if this intervention is bringing us stability. [1:40]

DOUG: Hi, Jim. Yeah, that’s right. You know, a couple of years ago there was all this talk about the Fed’s exit strategy and you even heard similar talk of an ECB exit strategy, but I’ve always had the view that there would be no exit strategy and the reason for that was -- I have a very credit-centric analytical framework, and when you have these credit booms, and every year the scope of the credit excess only grows larger and larger, you end up distorting price levels throughout the economy, throughout the markets. And a lot of this is, you know, old Austrian analysis and the problem is it takes ongoing rampant credit growth to keep these price levels sustained. And we saw in ’08 how quickly the economy and market started to unravel when all of a sudden the spigot from mortgage credit was turned down. 

And basically since ’08, it’s just been a matter of trying to keep credit flowing through the US economy and it’s predominantly federal credit. A lot of it is monetized by the Fed and a lot of the efforts here are to keep financial markets strong and that would be the bond market, the stock market -- risk markets generally. And I always believed that it won’t succeed because the policy response has to get bigger and bigger every year, as we’ve seen, and the markets only become more distorted and more speculative. And it just creates a lot of economic and financial fragility. 

And it is certainly worth noting, last fall towards -- going into 2011, we had a major financial crisis unfolding in Europe where the Italian debt market turned illiquid; where debt markets generally were illiquid and they were questions as far as the solvency of the banking system and the ECB responds dramatically with a 1.3 trillion -- and that’s in US dollars -- the long term liquidity operations. And that was just an enormous, enormous policy response, but it essentially brought Spain three months. So I think we're to the point now where you know, the policy responses have to be so enormous but yet the impact to the economy, to the markets, and importantly, to the underlying debt crisis is very minimal. 

So it’s interesting, we're at the point now especially here in the US where there is so much complacency where everyone just assumes, okay, when we need more fed stimulus, QE3, 4, 5, whatever, the Fed will be there. So there’s a lot of complacency here. At the same time, we're seeing globally we're at this dangerous phase where these aggressive operations are not having much of an impact. So it’s all kind of ominous to me. [4:21]

JIM: It seems that if I were to sum up what you just said, Doug, we’re getting less bang for the buck. I mean you talked about the 1.3 trillion with the LTRO program coming from the ECB and yet, I’m looking at my Bloomberg screen, Spanish bond yields are at a perilous 6.4, Portugal’s up 11 ½. But then I look at the bond market itself and it seems there are few islands of safety; Treasury bonds have obviously done well in this market, we’re looking at 1.7 on the 10 year and the German Bund is at 1.35. So I mean are we going to be talking about some day we’ll see German Bunds below 1% and Treasury yields below 1% because they’re the only islands of safety? [5:08]

DOUG: Nothing would surprise me when it comes to Bund and Treasury yields. And there is a lot of focus for obvious reasons on Greece right now; we have the election coming in a few weeks. But I think really the important point here is that the European debt crisis has finally gravitated from the periphery to the core. So whether Greece is in or out of the euro, Spain has a significant problem, Italy has a significant problem; those types of problems will likely move to France over the coming months. The market doesn't trust the debt; the economies have started a real downward spiral and there is very little the policy makers can do to change the situation because the market doesn't trust the sovereign debt and the banking systems have enormous problems. 

So the thesis from my point of view last year was that Europe had the potential to be a catalyst for a bout of global derisking and deleveraging; I saw that start to unfold last year, although it was interrupted by the LTRO. But really all the LTRO did was lead to a huge short squeeze in global risk markets and unwind of derivative hedges. It turned risk markets very speculative again. It led banks in Spain and Italy in particular to take on a lot more sovereign risk. So in my analysis, it just created a much more fragile situation. And we're seeing that unfold now where the risk is seen, you know, across different asset classes and especially when the markets start to fear that the hedge funds could be derisking and deleveraging again, and it quickly spreads to risk markets all over the world. It’s just a very, very treacherous environment out there in the risk markets, but again, that leads to a bid to Treasuries and to Bunds. And I’ll also say, this bid to Treasuries is very important; from my thesis, the Treasury market is a bubble. It’s part of this global government finance bubble. And ironically, the bursting of the European debt bubble has led to a collapse of yields in Treasuries and ease of financing our enormous deficits here. So in a way, Europe’s ills right now have led to somewhat of a boost here in the US. Although, I think now we’ll see the global economy slowing and there’s no way we can avoid the impact of that. [7:30]

JIM: When you look at the Treasury spreads and you look at yields out there, Doug, isn’t the low yields that the Fed is trying to enforce, whether it’s Operation Twist, I mean I’m looking at a one-year Treasury bill that’s less than 20 basis points, we have money-market funds what I’ve seen it takes about 35 basis points or almost half a percent to run a money-market fund. And yet we have new regulations; they want the money-market funds to post some kind of collateral or reserves similar to what we have in the banking system. How does this market work in this kind of environment? In other words, people are going to cash; they’re getting zero for cash and the people that are running cash, how do they earn rates of return that cover expenses? [8:17]

DOUG: Very difficult to do. And I think this is just part of Federal Reserve policy trying to incite savers out to become investors and speculators; right? Everyone knows that as Warren Buffet has said, it’s stupid to sit in cash. So I think policy makers, that’s part of their plan to force investors into riskier asset classes. It’s all part of what I would say is a very dangerous mispricing of finance throughout the whole economy, although the consequences of that aren’t really seen today, but they'll be seen down the road when we get into the next severe credit crisis here in the US. [8:56]

JIM: How do investors play this? I mean, I think there is a real risk if you’re chasing bond yields when they’re at 1.7, whether you’re looking at a 10-year Treasury here or looking at German Bunds at 1.35, you know, something that I’m seeing that we haven't seen for a long time, you actually have the yield on the Dow and the S&P actually higher than 10-year Treasury notes. Doug, can you remember the last time we saw something like that? [9:19]

DOUG: No, I can not. To me this is just an extraordinary, unique environment. It’s interesting to me because there is a lot of talk about how cheap US stocks are. And to me it’s kind of a classic value trap in that the yields are decent, especially compared to Treasuries and profit growth is respectable and even GDP growth is respectable. But I would warn that the real issue here is the underlying finance driving US economic growth and driving US corporate profits in the stock market is unstable. Global finance is unstable. And I certainly believe the US credit growth right now, predominantly Treasury debt, you don’t want to extrapolate a trillion dollar deficits as far as the eye can see; that is something that got investors in trouble, certainly in Europe. [10:08]

JIM: Doug, how does this play out. I mean now you have sort of a change in the political make up in Europe; instead of “Merkozy”, you have Hollande who is basically talking about, “Look, austerity isn't working. We need to get something going in terms of growth.” So given the moribund economies of Europe, how do you get growth other than some kind of QE or, I don’t know, maybe they try infrastructure investing? But how does that work because you have a currency union with no fiscal union? And it reminds me of what Ray Dalio recently penned in Barron’s in an interview; it’s kind of like our Articles of Confederation right after the Revolutionary War where we had Continental dollars, but we didn’t have a fiscal union, which later came about when we came up with the Consitution. Is this what Europe is going to have to do to get this under control? Or does this whole thing implode? [11:07]

DOUG: I fear that, you know, we have a cataclysm coming in Europe, and I don’t know if it’s the coming months or if they could stretch this out for another two or three years. And I’ve been a fan of the euro; I really hoped it would work. I was hoping we were going to have a new currency, a new reserve currency globally that would be part of the solution as far as this anchorless global financial system that we've been operating with. It’s now clear in my mind that it’s not going to work. It’s also part of my thesis that the further that we move into this global debt crisis, the more the Germans will believe that they need to protect their institutions, certainly their banking system, and importantly, their sovereign credit rating. So the political winds are shifting. 

Austerity hasn’t worked as well as folks would have hoped, but there is no easy solution when the markets don’t want to buy the underlying debt. The new socialist president in France asked a question last week, “Is it fair that one country in the eurozone borrows at zero, when another one borrows at 6%?” Is that fair? Well, if that’s the way the market prices sovereign debt risk, that’s the way it is and you’re not going to be able to change that. 

So I think in Germany right now, they’ll really work to protect the creditworthiness of their system. I don’t see them moving towards the eurobond solution. Certainly, they’re going to give some and there’ll be more growth policies. The European investment bank will have more latitude to lend, and there will be various measures to try to stimulate growth, but nothing that will make much headway in the midst of what is right now a really steep economic decline in some of these countries and a significant tightening of bank credit in particular. So no solution to these type of credit problems. 

We've certainly seen confirmation in Europe that at the end of the day what really matters is economic structure. We see now when the credit spigot is turned off in Greece, Italy and Spain, that those economies don’t function well. And unfortunately, it’s just going to take years of wrenching adjustments, structural adjustments to create a more stable European economy. And I don’t think the euro can last that long, unfortunately. I think at the end of the day we’re going to have a breakdown of euro monetary union. 

I hope I’m wrong on that, but that seems the direction it’s going right now. [13:30]

JIM: So at some point, things are going well in Germany and they’ve gone through hyperinflations, so what you’re implying is if this doesn't get solved, the Germans in the end may have to abandon the system if it comes down to self-preservation?

DOUG: I think so. Germany has one heck of a boom going on right now and part of that is their yields are so low. They actually need higher market yields when the periphery needs much lower. But that’s not the way these dysfunctional markets are going to allocate finance right now. So I know the perception is in the marketplace at the end of the day the Germans will do a risk-versus-reward type of analysis and believe that it’s a greater risk to them if the euro unravels. But I just don’t see how that society right now will be willing to take on the debts of these peripheral countries. And I think at this point, that’s the only thing that can stave off a pretty dramatic economic and financial crisis. [14:33]

JIM: All right. Well, listen, Doug, I want to thank you for joining us here on the Financial Sense Newshour. If you’d like to follow Doug’s work, you can do so by going to www.prudentbear.com. That’s www.prudentbear.com where you can see Doug’s weekly commentary The Credit Bubble Bulletin, which was very prescient in highlighting many of the issues that we've seen unfold over the last decade.