Is the Central Banking Bubble Bursting?

America's economy is stuck in first gear, China's economic growth is slowing, Europe's economy is dead in the water, and Japan's economy has been lost in a fog bank for decades.  Corporate profits have been declining on a year-to-year basis.  But stocks keep reaching new highs.  Given the backdrop of pessimistic data from the real world, one must wonder how much longer the delirious jollity of the markets can continue.

It's no secret that the frothiness of stocks stems from the service-minded attitude of the world's major central banks:  they aim to please.  Accommodation is the word of the day.  Money will be printed early and often, and served on a silver platter with a flute of champagne.  The central bankers are not about to take the champagne away, even though some Federal Reserve officials occasionally mutter something or other about raising rates.  The markets know this--the futures market seem to view rate rises as likely as pigs flying.  So the central bank bubble persists.

It's true that the central banks' tools are becoming dull.  Quantitative easing--the purchasing of bonds by central banks--is playing out.  Vast amounts of government bonds have been bought up, and now corporate bonds are being targeted.  Private sector retirement savings are being pummeled by the lack of sources of reliable long term earnings.  Pension fund deficits are like festering sores, annuity payouts are shrinking, long care insurance policies are becoming extortionately expensive, and interest payments on personal savings are going the way of the passenger pigeon.  With shrinking retirement prospects, people are saving more so that they can limit the need for dog food in their retirement diets.  As a result, both current and future consumption are constrained.  Since consumption is 70% of the U.S. economy, the Fed is seeking short gains in aggregate economic statistics by sacrificing long term financial prospects.  We've had eight years of ultra low interest rates with no end in sight, and recovery from the resulting income losses will take many years, if it ever happens.

More recently, the monetary tool that has become au courant among central bankers is the negative interest rate.  Negative rates are a counter-intuitive policy where borrowers are paid to take out loans.  They are supposed to stimulate lending by penalizing commercial banks for holding deposits.  However, despite being all the rage among central banks in Europe and Japan, they haven't worked out. It seems that people, concerned by the weirdness of negative rates, aren't borrowing but instead are saving more.   See http://www.cnbc.com/2016/08/09/bonds-and-debt-negative-yields-are-doing-the-opposite-of-what-they-were-intended.html.  Negative interest rates signal that the world is not well.  People are hunkering down and building up financial reserves in case times get worse.  This, too, dampens consumption and current economic growth.

But the deleterious effects of ultra low and negative interest rates are more likely to cause further economic stagnation, not a sudden collapse of stock prices.  The reality is that central banks aren't subject to market forces the way the rest of us are.  They are, however, subject to a lot of political pressure to keep current economic statistics looking good.  They know that the political process is largely dysfunctional, and fiscal proactivity isn't on the agenda. So they keep exchanging small near term benefits for large long term costs without any immediate consequence.  The bubble won't burst simply because they are making a bad long term deal. 

Could the central banking bubble burst?  The breakup of the EU might do the trick.  A return of significant inflation would be a major risk factor.  But it's hard to predict the likelihood of either.  In the meantime, stock prices could remain manically frothy.  Central banks can't defeat market forces when the market works against them, as the Bank of England found out in 1992 when it tried to support an overvalued pound against market forces pushing the pound down.  But right now, the financial markets want the central banks to be accommodative.  They applaud the idea.  Since the central banks face no reality checks, they can keep printing money indefinitely.

So, should you suspend belief and keep buying stocks?  Certainly, seeing stocks go ever higher just about every day is encouragement to drink the Kool-Aid and invest more.  But staying well-diversified, with a healthy dollop of cash, may be the sanest choice in an insane world.

The EU Bubble

Today's kerfluffle in the stock markets over the debt default of an entity affiliated with Portugal's largest bank reminds us that if there is a financial bubble anywhere, it's in EU sovereign and bank debt.  EU sovereign debt and the debt of EU banks have become almost synonymous.  That's because they are linked by a problematic circularity.  EU banks have invested heavily in EU sovereign debt.  EU nations, in turn, have pretty much become the guarantors of the debts of their banks.  Thus, the banks borrow to invest in sovereign debt, and the sovereigns in turn guarantee the banks' debt that funds the sovereigns.  It's rather clever, as long as nothing goes wrong.

However, one could note that EU banks and sovereign nations appear to be burdened with each others' liabilities, and that the guarantees of EU nations accordingly have limited efficacy.  Given that the EU and its banks, in toto, can be reasonably described as overleveraged, this circularity can become a circular firing squad if there is a run on a major EU bank or an EU sovereign member nation.  This is particularly so since no EU nation can issue its own currency and pay its or its banks' debts with printed money.

Of course, the European Central Bank has in recent years made a show of pointing to shining armor it could don and white horses it could mount to ride to the rescue if there is another European financial crisis.  And it has adopted accommodative, money printing-like maneuvers when the going got tough (like letting EU banks use sovereign debt as collateral for borrowings at the ECB without any discounting of their face value).  If the dustup across the pond is limited to Portugal, the ECB should be able to find one way or another to keep the cookie from crumbling.  But if other EU nations, particularly larger ones like France, begin to waver, the EU financial bubble could burst in a nasty way.  The economic consequences could be bad.  Given the growing extremism in Europe, the political consequences could be worse.

There are some asset classes in the U.S. that may be getting bubbly.  Many Internet stocks are suspect. Housing except for the $1 million and up price range seems to be struggling.  In addition, small cap stocks haven't been doing well recently and may turn out to be a bubble bursting.  But it's unlikely that the frothiness of these asset classes could re-trigger the Great Recession.   On the other hand, if the EU sovereign nations can't keep their banking systems on an even keel, then all bets are off. 

A New Dawn at the Fed?

On Tuesday, Oct. 18, 2011, Chairman Ben Bernanke of the Federal Reserve said that the central bank might use monetary policy to deflate asset bubbles. In other words, if the Fed saw a potential bubble brewing, it might raise interest rates to cool things down before a whole lot of people got badly hurt.

This is a big step forward. Before you can solve a problem, you have to recognize that you have a problem. Previously, Chairman Bernanke seemed to be of the view that the Fed couldn't see a bubble, hear a bubble or speak of a bubble--at least not before the bubble painfully burst. That was problematic, since the Fed was a serial enabler of bubbles, with its periodic fire sales on credit and new paradigms. While it takes more than the Fed to tango in this respect--greedy, cynical, and manipulative banks and other market players are usually the leading dramatis personae--the central bank is the gatekeeper. It controls the cash spigot. Bubbles require cash, and a lot of cash, to thrive. The Fed decides how much cash will slosh around the financial system. The more it opens the floodgates, the bubblier things get. Conversely, shortening the shifts for the employees at the Fed's monetary printing press will drain off the punch bowl just as the party is warming up. The Fed can feed or starve the bubble, as it chooses.

In the past, the Fed hasn't wrassled with asset bubbles, which like gators are strong, mean and destructive. But if you don't get control over the gator, who knows where it will go and what it will do? While Bernanke didn't admit that the Fed has been an enabler of asset bubbles, he's taken a big step forward in acknowledging that the central bank can't sit idly by while the financial system dashes up to the edge of a cliff and positions its feet half over the edge.