The Fed, Chinese Tightening and Distribution

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Federal Reserve Bank of St. Louis President James Bullard (February 21, 2013): “Let me just talk a minute about Jeremy Stein’s speech – governor Stein is a Harvard finance professor – surely one of the leading finance people in the world. And we’re fortunate to have him on the [Federal Reserve] Board of Governors. He came out to a conference in St. Louis a couple of weeks ago and gave a speech in which he talked about potential imbalances in financial markets in the U.S. and a little bit around the world. The first point to make would be that – my main take away from the speech - he pushed back some against the ‘Bernanke doctrine.’ The Bernanke doctrine has been that we’re going to use monetary policy to deal with normal macro-economic concerns and then we’ll use regulatory policy to try to contain financial excess. And Jeremy Stein’s speech said, in effect, ‘I’m not sure that you’re always going to be able to take care of the financial excess with the regulatory policy.’ And in a key line, he said, ‘Raising interest rates is a way to get into all the corners of the financial markets that you might not be able to see or you might not be able to attack with the regulatory approach.’ I thought this was interesting and I would certainly listen to him. Everyone should take heed of this. This is an argument that maybe you should think about using interest rates to fight financial excess a little more than we have in the last few years where we’ve always said we’re going to use regulatory policies in that dimension. I thought it was a very interesting speech, but let me give a little broader context. The Fed has been talking about asset bubbles since the ‘irrational exuberance’ speech which was 1996. So it’s nothing new. We had a big bubble in the nineties. A big bubble in the two thousands. Those two bubbles ended very differently. The Fed’s been talking, talking, talking about this. So it’s certainly been a concern. It is a concern today. But it’s like nothing new. This has been going on for 20 years. Frankly, there aren’t good answers because we don’t have great models of financial instability.”

For the second straight month, the release of the most recent (January 29-30) Federal Open Market Committee (FOMC) meeting somewhat rattled the markets. From the New York Times (Binyamin Appelbaum): “There are widening divisions among Federal Reserve officials about the value of its efforts to reduce unemployment, but supporters of those efforts remain firmly in control… An increasingly vocal minority of Fed officials are concerned that buying about $85 billion of Treasury securities and mortgage-backed securities each month is doing more harm than good. They argue the purchases may need to end even before unemployment drops, because the Fed’s efforts are encouraging excessive risk-taking and may be difficult to reverse.”

There is dissention as well as confusion at our central bank. There are (“many”) members that believe open-ended QE was a mistake – and that this policy error should be corrected as soon as possible. Others believe aggressive QE could be continued indefinitely, or at least until unemployment has been reduced to a comfortable level. There is broad disagreement as to impacts, benefits and costs associated with the Fed’s long-term zero rate policy, quantitative easing, the mix of asset purchases, the ongoing balance sheet expansion (and, supposedly, eventual “exit”), pre-committing on the future course of policy and communications more generally. While no one wants to admit as much, it’s all become one big and consequential mess. 

Those bullish on U.S. equities can easily ignore this increasingly contentious and complex debate. Understandably, they remain confident that Bernanke, Yellen, Dudley, Evans, Williams and Co. will continue to dictate ultra-easy policy for some years to come. What more do you need to know? And it is not outlandish to surmise that the more the doves’ “inflationist” strategy is called into question, the more insular and intransigent this group becomes.

There are those that believe that the Federal Reserve and global central bankers are on the right course. If QE/money printing is not getting the desired results, it’s because central banks aren’t using it with sufficient determination. And then there are those of us that see global monetary policy as an unmitigated disaster. Dr. Bullard is certainly accurate when he states “We had a big bubble in the nineties. A big bubble in the two thousands… This has been going on for 20 years.”

By now, the “Greenspan doctrine” of unfettered market-based finance and asymmetrical policy responses should have been completely discredited. Ditto for the “Greenspan/Bernanke doctrine” of disregarding assets Bubbles while they’re inflating, focusing instead on reflationary monetary measures to “mop up” after they’ve burst. By accommodating even bigger – and more systemic - Bubbles, the Fed has perpetrated even bigger policy debacles. And we should today look at the “Bernanke doctrine” – “Use monetary policy to deal with normal macro-economic concerns and then we’ll use regulatory policy to try to contain financial excess” with heightened skepticism and outright alarm. 

Please explain how “regulatory policy” is to address the unprecedented issuance of government debt coupled with unconventional experimental reflationary monetary policy – the heart of today’s “global government finance Bubble”? It hasn’t – and it won’t. And, clearly, I’m not alone in recognizing the obvious: The Fed has become a rather conspicuous enabler of Washington fiscal dysfunction. The Fed has become an enabler of global speculation, along with ever-mounting financial and economic imbalances. The debate is not going away – and the timing of the wind down in the most recent batch of quantitative easing is not the real issue.

Yet the sophisticated market operators’ immediate focus is to gauge when global “risk on” might be imperiled by the Fed’s backtracking from its $85bn monthly money printing operation. Upon deeper inspection, however, one can see a central bank institution that’s flailing. They’ve opened the money printing Pandora’s Box – without a doctrine, a strategy or even a consensus view for how to approach its latest experiment with “open-ended” quantitative easing. I believe the decision to proceed with aggressive liquidity creation was based more on global systemic issues than the U.S. jobless rate. But in reversing last year’s potentially destabilizing global “risk off,” the Fed and global central bankers incited a historic period of “risk on” excess and attendant fragilities. Now they’re stuck.

A lot is riding on the current “risk on.” Six months ago, the consensus view was that monetary policy was largely out of ammunition. Today, irrational exuberance has central bankers enjoying unlimited firepower. Central banks will be there the moment markets require additional liquidity. And the more markets inflate, the more confident players are with notion that central bankers won’t dare rock the applecart. It’s increasingly clear that “risk on” comes with heightened excesses and imbalances. Let’s quickly go around the globe.

The Shanghai Composite sank 4.9% this week. Markets increasingly fear a government imposed tightening cycle in China. Recall that Chinese officials were in the process of attempting to cool an overheated economy and a national housing Bubble before the “European” crisis last year risked unwieldy downturns. Officials cautiously retreated from measured “tightening” and, as Bubbles tend to do in the face of timid policymaking, the Chinese economic, Credit and Housing market Bubbles sprung right back. Housing transactions have surged, price inflation has accelerated and Credit growth has gone from amazing to utterly astounding. Reports put total January system lending (“social financing”) at an incredible $400bn. There is the distinct possibility that the Chinese Credit boom has reached the point of being, literally, out of control.

Importantly, global “risk on” - with attendant liquidity and “hot money” bonanzas - has worked to reenergize China’s historic Bubble. The bullish consensus view holds that Chinese leaders have their economy and Credit system well under control. Yet each passing year of Bubble excess – certainly exacerbated by global liquidity oversupply and timid domestic policy – ensures that myriad imbalances become more deeply embedded in financial and economic structures.

There were indications this week that Chinese authorities are again moving to tighten housing finance (see “China Bubble Watch” below). On the one hand, the consensus view holds that the Chinese will approach tightening gingerly. And, at this point, global markets seem rather numb to Chinese tightening risks. On the other hand, with Credit Bubble infrastructure and psychology now deeply embedded, authorities will need to inflict some real pain (break inflationary psychology) if they are indeed determined to see results.

I would argue that a new Chinese tightening cycle would come with huge uncertainties and major unappreciated risks. Indeed, it could mark a significant inflection point for Chinese Credit, the imbalanced Chinese economy and global economies and markets more generally. It is worth noting that tin and nickel prices were down 7% this week, with silver, platinum and copper all down more than 5%.

A lot has transpired in China over the past year. The Chinese people – and the world more generally - have become much more aware of China’s endemic corruption problem. Widespread toxic air (and water) pollution has also been recognized as a consequence of a runaway Chinese boom. Other more typical Credit inflation consequences – notably asset Bubbles, widening wealth disparities and economic imbalances – have also become more pressing. Moreover, inflation continues to quietly impart pain upon the large population of impoverished Chinese. The new Chinese government faces daunting financial, economic, environmental and social challenges. The global love affair with money printing (QE) doesn’t today seem to work in their best interest.

When I ponder a future bursting of the Chinese Bubble, I fret China’s relationship with Japan. For now, however, we’ll focus on the yen and Japanese stocks and bonds. The hedge funds have placed big bearish bets on Japan’s currency, while yen weakness has fueled heightened speculation in Japanese equities and, likely, global “risk on” “carry trades” more generally. Markets this week seemed to indicate that a yen rally might endanger an increasingly vulnerable global “risk on” market backdrop. And if “risk on” is viewed as susceptible, yen weakness might not be such a sure one-way bet.

This week also provided added confirmation of European vulnerabilities. For starters, the euro dropped 1.4%. Euro weakness also seemed to pressure global “risk on.” Euro-zone economic data was generally dismal. PMI manufacturing and services indices were indicative of economic contraction. “Core” country France, in particular, was notable for signs of deepening recession. France’s “composite” PMI index of manufacturing and services index declined to 42.3 (from January’s 42.7), the low since 2009. And then on Friday, the European Commission again downgraded Europe’s growth prospects. Euro zone GDP is now expected to contract 0.3% in 2013, with unemployment climbing to 12.2%.

A Reuters’ headline captured a growing market issue: “Core Problem for Europe as France and Germany Drift Apart.” Elsewhere, Spain’s 2012 deficit was reported at 10.2%. And Sunday commences the two-day Italian election, almost sure to raise concerns regarding Italy’s commitment to reform and the political stability to carry on with commitments. This week seemed to bring a spotlight on the huge chasm that has developed between “risk on” market levels and the region’s troubling fundamental backdrop.

I always find it fascinating how news and analyses follow the direction of the market. When the markets are strong, the media focuses on the positives and are content to disregard the negatives. As markets reversed this week, suddenly there’s awareness that the European economy remains a mess, the U.S. still has serious fiscal and monetary policy issues to address, and global growth dynamics remain challenged. News outlets also tend to find a simple explanation for market selloffs. This week, it was the Fed minutes – an issue conveniently dismissed by the reality that the Fed is under the tight control of the dovish contingent.

When one takes an objective view of the world, I along with others see a deeply flawed monetary policy experiment run amuck. I see myriad historic Bubbles. I see, as well, a global “risk on” speculative trading dynamic that will eventually impart pain upon the unsuspecting. The short-term is significantly less clear. Does the sophisticated leveraged speculating community continue to play “risk on” for all its worth? Or will a more susceptible global backdrop dictate a change in strategy? Will the speculating community now seek to begin selling their holdings to the less sophisticated rushing to participate in the “new bull market”? It’s traditionally called “distribution.” In today’s highly distorted financial backdrop, it’s probably more aptly referred to as “wealth redistribution.”

One could add wealth redistribution to the list of “unintended consequences” from Federal Reserve reflationary policymaking. That is, except for the fact that the Bernanke Fed is rather open in its view that it prefers savers out of safety and into the risk markets (jungle).

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About Douglas Noland