Editor's Note: This article was originally written May 19
This perspective posting examines the recent history of U.S. debt expansion, bubble formation and bubble deflation, as narrated by the S&P500, and speculates on future economic conditions and the behaviour of asset prices.
“There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt)expansion or later as a final and total catastrophe of the currency system involved.”
Ludwig von Mises (1881- 1973), Austrian economist
Whether by design or by default, over the recent history (for the past 15 years and counting, with a beginning marked by the dawn of the internet/information revolution), the U.S. economy appears to be undergoing recurring episodes of debt expansion, bubble formation, and bubble deflation. The chart below superimposes near term macro-economic events onto the S&P500 price graph.
In the first wave of U.S. debt expansion, the Federal Reserve maintained its policy benchmark borrowing rate in a historically low range of 5%-6% between 1994 and 2000. Although this helped to drive economic growth and corporate earnings, in hindsight, it appeared to have also led to the formation of a stock market bubble. The S&P500 moved higher by approximately 300% (from 500 to 1,550), as did global equity indices to various degrees.
As the stock market bubble began to deflate in early 2000, led by a deflation of technology and internet company share prices, the Fed began reducing its policy rate, reaching 3.5% just prior to 11-Sep-01. With tragedy unfolding on that fateful day, the Fed continued reducing its policy rate to 1% into 2004. This second round of debt expansion helped to reflate equity markets (the S&P500 rallied by nearly 100% during 2003-2007) and conceivably triggered the formation of the U.S. housing real estate bubble. With interest rates at an historic trough during this period, investor risk tolerance grew once more, driving credit spreads to record lows, as investors aggressively sought yield to compensate for what little yield sovereign fixed income debt was returning. The Fed gradually raised its policy rate back to 5% during 2005-2007, with virtually no impact on investor appetite for risk, as equities remained lofty and credit spreads remained irrationally and exuberantly narrow.
As the U.S. housing bubble began to deflate (and by extension the valuation of financial organizations with direct or derivative exposure) with spillover effects into equity markets, the Fed aggressively and rapidly lowered its policy rate to near zero. Having exhausted its capacity to lower its policy rate further and in an effort to bring down long term rates to ward off what it saw as deflationary pressures, the Fed began effectively to print dollars under its program of quantitative easing, in order to acquire debt investments (e.g. mortgage and other asset-backed securities) previously held by financial institutions that were deemed too big to fail, which they were at risk of doing as the U.S. housing bubble burst. With borrowing costs at another record trough, the U.S. government, in turn, began to grow its appetite for fiscal risk (borrowing to fund its growing budget deficit), something which the Fed has accommodated through its QE programs by buying surplus treasury supply. This third phase of debt expansion has helped to reflate equity markets (the S&P500 has so far rallied by nearly 100% from the depth of the global financial crisis of 2008-2009), but appears to have had a relatively subdued impact on the reflation of U.S. housing.
The Fed’s QEI and QEII programs and its acquisition of surplus government debt have artificially kept down the cost (yield) of government debt. The inverse relationship between yield and price for debt instruments is well understood but worth reiterating. In keeping the yield on debt artificially low, the Fed has maintained the price of debt artificially high and has conceivably contributed to the formation of a U.S. government debt bubble (debt price artificially high amidst ample and exponentially growing supply). QEII is scheduled to end in June, 2011 and the Fed has not ruled out a 3rd round (QEIII). With the U.S. government deficit running at a record pace, it is difficult to envision government bond yields remaining as subdued as they are without continuous Fed buying. Should it come to pass, QEIII would contribute further to the formation of the government debt bubble by keeping interest rates low and debt prices high, even as supply continues to grow rapidly. The continued debt expansion would likely support a further rally in the S&P500, as have previous Fed-engineered debt expansion programs.
Although no one can accurately predict whether QEIII will come to pass, or how much further the S&P500 may rally as a result, it is noteworthy that the S&P500 peaked around 1,575 twice over the past 15 years; once before the deflation of the stock bubble in early 2000 and once more before the deflation of the housing bubble in early 2007. To those who are versed in technical analysis, a triple top of 1,575 in the S&P500 could be on the medium term horizon and may be supported by a 3rd round of quantitative easing, implying a potential further rally of 15%-20% in the S&P500, especially if QEIII is implemented.
It is worth exploring whether there is a meaningful positive correlation between important turning points in economic conditions and technical chart analysis. There are small scale turning points (economic data surprises) that coincide with important technical levels over the near term, as there are macro turning points (bubble peaks) that coincide with technical levels (or reasonably narrow ranges) over longer investment horizons, such as used in the chart presented. Technical analysis is both a science and an art with many investors, small and large, exclusively using this approach to invest, or in some combination with fundamental analysis (company financial statements for individual securities investing or economic fundamentals for macro investing).
The global economy, led by the leading economy, the U.S., appears to have embarked on a journey of debt expansion, followed by boom and bust on a significant scale, as narrated by the S&P500. With the U.S. budget deficit at nearly .5 trillion and growing, the U.S. is on a third leg of its debt expansion journey, with generous assistance from the Fed in ensuring appropriate demand in order to keep the cost of borrowing (yield) down and the proceeds of borrowing (price) high. Many important players have begun to react to the bubble-like symptoms of the U.S. treasury market. PIMCO, for example, is one of the largest (if not the largest) fixed income investor in the world and has been reported to have sold its treasury inventory (one can believe they may have at least significantly reduced their asset allocation to treasuries). Other important participants such as China’s central bank have voiced concerns over large treasury holdings and U.S. fiscal policy. Surely it would be reasonable to assume that the Chinese may consider taking profit on at least a portion of a generously marked-to-market portfolio of U.S. treasuries, as they look to potentially diversify their asset mix into other classes. As to the argument of where the Chinese would invest these proceeds, their domestic economy would be one choice. An appreciating Yuan could be a potential negative for China’s export market, but any weakness from marginally lower exports could be offset by government spending in its domestic economy. It is conceivable that a Chinese domestic and consumer market is growing and could one day rival that which has existed in the U.S., where GDP has been 2/3 consumer spending.
A natural point to consider is the approximate time period when one can expect the U.S. government debt (price) bubble to begin deflating and its implications. The formation of bubbles is a relatively long process, and most guesses as to their imminent demise are often wrong. As with previous bubbles, the formation of a government debt bubble and its ultimate deflation will likely prove just as difficult to accurately time. But deflate it will, as all bubbles ultimately do. If the trend is any friend, the S&P500 chart presented could suggest from a purely technical viewpoint, the possibility of what is called a triple top should it reach a level somewhere between 1,550 and 1,600, which is 15%-20% higher from where it is today (1,340), sometime around the middle of 2012. By no means would this be a straight line trajectory and the S&P500 will likely correct from the current level of 1,340, perhaps falling to a range of 1,150-1,200, before rebounding in concert with the on-going formation of the government debt bubble.
By the middle of 2012, the debt bubble formation will have been approximately 4 years in the making, which seemed to have been the duration of the housing bubble formation and stock reflation after the second round of debt expansion. As a purely non-scientific observation, and this is where technical analysis becomes an art, the chart presented suggests the debt bubble peaking over a similar time frame, during which the S&P500 marks a technical triple top over a 15 year investment horizon. As mentioned, the demise of bubbles is very hard to predict. This observation is shared merely as a potential scenario, based on a recent history of debt formation and asset bubbles. Furthermore, one cannot rule out a manifestation of the price deflation of U.S. treasuries by means of a weaker U.S. dollar, which, in price terms, deflates the purchasing power of a U.S. treasuries investor’s proceeds. Against a basket of major currencies, the dollar has fallen merely 12-15% from the start of quantitative easing in Nov-08 to now. This would appear relatively modest in size to significantly slow the formation of the U.S. debt bubble in question.
The deflation of the stock and housing bubbles were accompanied by a flight to safety and quality, characteristics which have been typified by U.S. treasuries. With a .5 trillion deficit, tens of trillions more in debt and unfunded liabilities, and with rating agencies beginning to sound warnings on the credit worthiness of U.S. treasuries, safety and quality benchmarks become questionable. Furthermore, the deflation (in price terms) of a bubble involving the very investment, U.S. treasuries, which investors typically flee towards as ordinary asset bubbles burst creates a paradox. It is paradoxical to think of investors running to the safety of U.S. treasuries, if the bubble that is bursting is itself composed of price-inflated treasuries that have begun to deflate. A deflating debt bubble (in price terms) means higher interest rates, which generally represent inflation in the broad economy.
With debt itself being the bubble that deflates and drives interest rates higher as an inflationary phenomenon, the prospect of stagflation is worth considering. Economic stagnation accompanied by inflation is a potential outcome that would rationally explain how the deflation of the U.S. debt bubble may be accompanied by a deflating S&P500 (and U.S. equities in general). Given the nature of the bubble that is currently in the formative stage, which is of a nature that involves money and currency itself, stagflation would argue in favour of precious metals ahead of other commodities as a hedge against a stagnating economy that is experiencing inflation. The last episode of recorded stagflation history occurred in the 1970′s, during which time the U.S. economy experienced low to negative growth during a time of high inflation. It is worth noting that during this period of high interest rates and inflation, gold had moved higher in parabolic fashion, while equities remained largely flat, except for a major sell-off in the mid-1970′s, from which the market rebounded by the end of that decade. This time around, with a Fed that is inclined to continue providing liquidity, one may ask what would trigger the Fed to begin raising interest rates. The most likely trigger would be a disorderly decline in the value of the U.S. dollar, something which the Fed would be unable to control directly (as it does treasuries by buying surplus supply), except through interest rate policy. The dollar’s weakness has thus far been gradual, removing the Fed’s incentive to reverse course on rates. The watershed event that would most likely spur the Fed into switching to an aggressive rate policy change (higher rates) may likely come in the form of a rapidly depreciating dollar, an event whose probability will continue to grow during the formation of the U.S. government debt bubble underway, and which will likely trigger its inevitable deflation.